Difference between Personal Loan and Line of Credit Article

8/1/2018 12:00:00 AM - 2 min. read

Understanding the Difference between Personal Loans and Lines of Credit

The concept of taking out a loan is a really simple one. There are many times when borrowing is the best way for someone to meet a financial need. However, there are different types of loans that best serve different purposes. Here we’re going to take a closer look at the differences between personal loans and personal lines of credit to discuss when to use each.


Personal Loans vs. Lines of Credit:
What’s the Difference?

Personal loans are lump sum amounts that an individual borrows from a financial institution, such as a bank or credit union. These types of loans are installment loans with pre-calculated rates. What this means is that the borrower pays back the full amount of the loan in fixed monthly installments over the duration of the loan’s term period.

When people take out personal loans, it’s usually with a specific use in mind. It could be used in a number of ways, but some of the most common include traveling, tackling unexpected expenses, paying for special occasions, making large purchases, and consolidating other debts into a single monthly payment – generally with a lower interest rate.

Personal lines of credit are revolving loans, meaning the borrower has access to a predetermined sum, or credit limit that carries over from month to month. Out of that credit limit, the borrower can take what s/he needs as expenses arise. When funds are used, the borrower makes payments only on the amount actually borrowed rather than the full amount of the loan. In this way, a line of credit is more similar to a credit card.


Example Uses for Both Loan Types

Let’s say you found yourself preparing to buy new furniture for your home, but needing a bit more money than what you currently have in the budget. You might consider taking out a personal loan to handle the expense of the furniture, then pay back the loan in installments over time.

On the other hand, let’s say you were considering a couple home improvement projects. You know that you will run into various expenses along the way, but it’s hard to forecast what they might be or how much they may set you back. In this scenario, you might consider taking out a revolving line of credit so you can borrow what you need when you need it. As you pay off what you borrow, the amount paid becomes available for you to use again.


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Which Loan Should I Use?

When considering your loan options, it’s always best to start by reviewing your situation and your financial goals. Here are a few things to take into account when making your decision.


Interest Rates, Monthly Payments, and Financial Flexibility

Personal loans will generally have lower interest rates than lines of credit. That makes them the better option for larger purchases that you know you’ll need some time to pay off. The payments are fixed, which will help you prepare your budget and determine how quickly you are able to pay the loan off. In fact, after evaluating their monthly expenses, many people take out personal loans to pay off outstanding revolving debts, such as credit cards, because they can usually get a lower monthly payment.

Personal lines of credit might have more flexibility than installment loans, but the interest rates do tend to be higher. A borrower with a line of credit may go months without owing any payments, but when payments are due, the monthly totals are not fixed. This makes personal lines of credit great for ongoing projects or supplementing an emergency fund.


How Hard Is Getting Approved?

After weighing your options, it’s time to apply for a loan. If you’ve decided on a personal loan, you may be asked to choose between an unsecured or secured loan. What this means is that you might have to put up some type of collateral against the loan. Lenders generally look at several factors, including your credit score, debt-to-income ratio, and verifiable household income, just to name a few. Based on reviewing their lending criteria, you might be asked to put up some additional collateral – meaning you would be asked to take out a secured loan.

The application process for a line of credit might be a little different. For instance, each of the factors a lender considers when evaluating your application will probably be scrutinized more closely. Because of the variable-use nature of lines of credit, applicants usually have to meet stricter criteria to be granted approval. It is also pretty rare for lines of credit to be issued against collateral, so you aren’t likely to find many lenders offering secured lines of credit.


Importance of Collateral

When considering loan choices, it is extremely important to determine whether you’re completely comfortable with offering up something as collateral. Remember, it has to be something of value – such as property, stocks, or your savings – because this collateral is intended to protect the lender from a loss if you are unable to pay back your loan. However, if you have any doubts about your ability to pay back a loan, you probably shouldn’t be applying.

If you do feel sure that you won’t have any trouble managing your loan payment, it is perfectly acceptable to apply for a secured loan.

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Pro-Tip: Watch out for predatory lenders. It is not uncommon to hear about institutions who extend bad loans to desperate people. These are loans that have extremely high rates and tend to require very fast repayment, such as payday loans.


Managing Your Credit Score

When you apply for a loan or line of credit, the bank or credit union will check your credit history. This hard inquiry can drop your credit score by a few points temporarily. As long as you make timely payments, your credit score should recover fairly quickly. If you take out a line of credit, making sure to always keep as high an available balance as possible can also help. Having the credit available can actually improve your credit score over time.


Making the Choice for Yourself

Regardless of your financial need or what type of loans you are considering, it is important to weigh the pros and cons of your options. If you would like to speak with someone about whether you should apply for a personal loan or a line of credit, we recommend that you speak with a loan advisor from our Centralized Sales team.

Remember, our mission at First Service is to provide our members with financial products and services that enhance their lives. Let us help you to make the best decision to take control of your financial future.