When you need some extra cash, you may consider taking out a personal loan or a line of credit. Both have their own advantages and may be better suited to different situations, and both have important differences that you need to consider. In short, a loan is typically a lump sum, where as a line of credit is a revolving account that allows you to withdraw, repay and redraw available funds. Read on below to figure out which is right for your situation.
Personal Loan
A personal loan is a lump sum of money that you receive all at one time. Before you even receive the money, you will know over how long a period of time you have to pay the loan back (the loan term), and how much you will pay every month (monthly payment). You will normally start paying it back immediately.
You also begin paying it off immediately with predetermined monthly , and that you also begin paying off immediately.
A personal loan can come with fixed or variable interest rate; with fixed interest, the monthly payments will be exactly the same for the entire loan term. With a variable interest rate the payments can go up or down slightly.
A personal loan is therefore much like a mortgage or an auto loan, with the difference being that it is not made or a specific purpose, and it is not backed by any asset. This means you can use the money on whatever you like, and that the cost of the loan (the interest rate) will be higher because the loan is unsecured and is therefore more risky to the issuer.
Personal Line Of Credit
A personal line of credit is a type of revolving debt; to consumers it is available in the form of a credit card.
A personal line of credit has some opposite characteristics of a personal loan. You do not borrow a set loan amount, there is no predetermined period of time over which you have to pay the loan back, and there are no required monthly payments. You are simply given access to a set amount of cash to borrow from.
You can have a personal line of credit and never use it, and in such case it will not cost you anything in interest (this is not the same as the credit card being completely free to get and have; there might be fees associated with it). You only pay interest on the amount drawn from the line of credit, and only for the time period the amount stays outstanding. So, if you pay the amount back in three weeks you will pay less interest on it than if it takes you three months.
Like a personal loan, a line of credit is unsecured, and therefore usually comes with a high interest rate.
Which Of The Two Is Better?
Which of these two types of loans is better depends on your financial situations and the purpose for the money.
Your credit score is affected differently by them. Generally, a personal loan affects your credit score less negatively than a line of credit. On the other hand, to get a personal line of credit you will typically need a higher credit score to begin with. Personal loans can be found even with poor credit score - although the lower the credit score, the higher the interest rate on the personal loan.
If you are looking to make a specific, large purchase, a personal loan may make better sense as you know the exact amount you need. The personal loan will come with the security of knowing how much you will be paying in instalments each month, so that you can include it in your budgeting. Also, with a large purchase paid back over a longer period of time it will likely cost you less in interest than a personal line of credit.
On the other hand, if you don’t have a specific purchase in mind but are low on cash seasonally or are working on a project that requires different smaller purchases that can’t be known in advance (e.g. home repairs), a credit line may be better suited to your needs. This spares you paying interest on money that you don’t use, and gives you the flexibility to borrow again easily if you haven’t used up the full credit amount or have paid it back.
A personal line of credit can also be well-suited for emergency situations when you suddenly need access to cash right away.
Since you don’t have set instalments and continuous access to cash, it does require more discipline to pay back any outstanding amounts and to avoid using the personal credit line for unnecessary purchases.
Recap
Below is a quick recap of the most important points mentioned above on the difference between a personal loan and a personal line of credit. Keep in mind the different terms and potential costs that these different types of loans come with.
Personal loan:
- fixed amount, paid back over a fixed period of time, in fixed or variable monthly payments
- good when you know the exact amount you need, and the amount will take you at least several months to pay back
- expensive if you don’t know the amount you need, because you pay interest on money that you may just have sitting in your account unused
Personal line of credit:
- access to a predetermined amount, with no obligation to use it or any requirement for how long it takes you to pay it back
- good when you don’t know the exact amount you need, or when you have short periods of time with less cash on your hands
- expensive for large purchases
- expensive if you don’t start paying back the borrowed amount quickly, as the interest is higher than with a personal loan
Resources:
1. https://www.fool.com/the-ascent/personal-loans/articles/what-is-difference-between-personal-loan-and-personal-line-credit/
2. https://www.bankrate.com/loans/personal-loans/personal-loan-line-of-credit/
3. https://www.creditkarma.com/personal-loans/i/line-of-credit-vs-loan/
4. https://www.investopedia.com/ask/answers/102814/how-interest-charged-most-lines-credit.asp
