Which offers better terms? A personal loan or line of credit? The answer is in the details.
With the extreme variety in today’s financing options, it can get very confusing when deciding between two basic borrowing options: personal loans or lines of credit. Each has its own advantages and disadvantages, but making the wrong choice could be very expensive. Choosing the most appropriate option for your situation could potentially save you lots of money in interest and fees.
Six main differences between personal loans and lines of credit
- Loan term. Personal loans have a predetermined term length, usually between one and seven years. They’re paid back in full by the end of that term. However, lines of credit don’t come with a set repayment period, and the funds you borrow become available again after they’re repaid (plus interest).
- Repayments. Both involve monthly repayments. However, personal loans have fixed monthly repayments while lines of credit depend on the previous balance, amount drawn, accruing interest and other factors.
- Time of disbursement. With personal loans, your lender will disburse your funds upfront as soon as you agree on the loan contract and sign it. With lines of credit, you’re able to withdraw up to your approved limit on an ongoing basis as long as you’re meeting minimum monthly repayments.
- Fees. Personal loans usually charge monthly service and application fees while lines of credit usually charge annual service fees. However, lenders for both personal loans as well as lines of credit may charge a variety of other hidden fees. Make sure you’re aware of all fees for any option you’re considering.
- Borrowing amounts. With a personal loan, you’re given a lump sum of money that you have to pay back in full. Lines of credit come with a borrowing limit instead — similar to a credit card. This means you can take what you need, when you need it.
- Costs. Being able to borrow only what you need can make lines of credit less expensive. This is because you’re be on the hook for less money — and therefore less interest. Even if your rates are higher than a personal loan.
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Benefits of personal loans and lines of credit
Personal loans provide your funds upfront and stipulate an agreed time period to pay back your loan (called the “loan term”). Interest is charged on the entire duration of your loan term and on your entire loan amount. In general, most personal loans involve the following features:
- Upfront lump-sum. Once the lender approves your application and you agree to the loan contract, you’ll receive all your funds upfront.
- Interest rate. Your lender will charge either a fixed interest rate that won’t change over the term of your loan, or a variable interest rate which can rise or fall depending on market rates. Learn more about the difference between fixed and variable interest rate loans.
- Term. The period over which you’ll be making repayments to fully pay back the loan is called the loan term. It generally ranges between one year and seven years.
- Discount rates. Your lender may offer you a limited time discount if you take out a significant loan amount.
- Flexible repayments. Depending on your lender, you may be able to choose exactly how and when you’ll be making monthly repayments.
Line of credit
Lines of credit have a maximum credit limit, and you’ll only be charged interest on the funds you actually use. Repayments are made monthly, but there’s no fixed “term” for a line of credit. As long as you’re making your minimum monthly repayments, your funds will always be available to you.
- Option to increase maximum credit limit. Your lender may provide an option to increase the maximum credit limit in line with your specific needs.
- Flexible withdrawals. You’ll be able to withdraw funds from your line of credit whenever you like, as long as it doesn’t exceed your maximum credit/daily limit.
- No fixed repayments. As long as you’re making a minimum required monthly payment (a percentage of withdrawn funds), there’s no fixed repayment amount.
- Interest rate. Interest is paid monthly and is only charged on the amount you borrowed.
Which borrowing option is better suited for you?
Lines of credit are helpful for those needing ongoing sources of funding to be used when they see fit. Since lines of credit are revolving, you won’t be charged on funds you don’t withdraw, making them an excellent option for backup sources of funding.
Since interest rates could get expensive for lines of credit, they are suited to those looking for flexibility with their credit and an ongoing source of funds for purchases such as paying bills, consolidating short-term debt and shopping.
Ultimately, a personal loan is suited to someone who wants structured repayments and an initial lump sum paid to them at the beginning of the loan term. A personal loan is well suited for those looking to make large purchases such as for a wedding or car using that lump sum. Also, a personal loan can be appropriate for those looking to consolidate a large amount of debt.
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