Loan vs. Line of Credit: What’s the Difference?
If you need money, you may be debating applying for a loan or a line of credit. Read on to decide which one might be right for you.
If you need to borrow money from a lender (financial institutions like banks or credit unions, not your friends or family), you have two main choices: you can take out a loan or get a line of credit. Both a loan and a line of credit provide you with funds, but they work differently. There are pros and cons associate with each, and the option that's the best fit for you may depend on why you need the money in the first place.
When you take out a loan, you borrow a lump sum of money that you get up front. Depending on the loan, the money may go directly to you, or it could go to a third party, the way certain student loans go directly to the school, for example. Loans have a fixed term, and they typically have a fixed interest rate—although a loan could also have a variable interest rate—so you generally pay the same amount each month over the life of the loan.
Because you’re paying off the loan in installments, a loan is considered to be installment credit. When you pay off the loan, the lender closes the account, so a loan is also considered closed-end credit. If you want to borrow any more money from that lender, you have to apply for a new loan.
There are two main types of loans: secured and unsecured. Secured loans are backed by collateral, such as your house or car, which the lender can typically seize if you don't make your payments or violate the terms of the loan. Unsecured loans, such as personal loans, are not backed by collateral. Because they're less risky for lenders, secured loans typically have lower interest rates than unsecured loans.
Lines of Credit
Unlike a loan, which is an installment credit account, a line of credit is a revolving credit account, which means you can continually borrow from it—so long as you don’t exceed the account’s credit limit and the account is in good standing. With a line of credit, you don't receive the full amount of the credit limit up front in a lump sum as you do with an installment loan. Instead, the lender approves you for a designated amount of money that's available for you to borrow as you need it, up to your credit limit. Of course, if you want to use the full amount of the line of credit as soon as it’s available, that’s up to you.
Once you use any of the line of credit’s available credit, that amount begins to accrue interest. Interest may be charged at a fixed or variable rate, depending on the terms of the line of credit. You then make monthly payments on money you’ve borrowed. Your monthly payment will depend on how much of your line of credit you’ve used, your interest rate, plus any fees, penalties, or other charges.
Your available credit goes down every time you borrow money from a line of credit. But, unlike with a standard installment loan, you can keep replenishing a line of credit by paying back what you’ve borrowed, which makes a line of credit open-end credit.
So, for example, if you have a $10,000 line of credit, and you borrow $3,000 from it, your available credit would then be $7,000. But, if you pay back the $3,000, plus any interest and fees owed, your available credit would revert back to $10,000, your credit limit. This is what makes a line of credit revolving credit; so long as you keep making payments and replenishing your available credit, you can keep a line of credit going for its draw period, which is the number of months or years you have to borrow from the line of credit being extended.
In this sense, a line of credit works very much like a credit card, only you’re getting money from the line of credit to make purchases instead of the purchasing power a credit card provides.
There are two main types of lines of credit: home equity lines of credit (HELOC) and personal lines of credit (PLOC). A HELOC is secured by your home, while a PLOC is unsecured. Because HELOCs are secured, they typically offer higher credit limits and have lower interest rates than PLOCs.
Credit cards technically provide card members with immediate short-term loans, so it’s worth mentioning them as a loan option. A credit card provides a merchant with the funds for goods or services you purchase from them, and then you are obligated to pay the credit card issuer back. But, unless it’s a cash advance, which we’ll cover next, you don’t get money directly from a credit card issuer.
So, if you didn’t have the funds available to pay your college tuition, you could pay it with your credit card rather than take out a student loan. However, this probably isn’t your best move for a number of reasons, including but not limited to the fact that interest rates on credit cards are typically substantially higher than on student loans. Plus, student loan payments can often be deferred until after graduation whereas credit card payments are due every month until the outstanding balance is paid in full.
Credit Card Cash Advances
A credit card cash advance is another way to get a quick infusion of cash but, again, it’s unlikely to be your most cost-effective option. If your credit card offers cash advances, you can use the card to get cash from an ATM or a bank. When you use your card for a cash advance, the amount you withdraw gets added to your outstanding balance, which you are then obligated to repay, just like regular credit card purchases.
Credit card cash advances may have even higher interest rates than standard purchases, and they typically don't offer a grace period, so the amount you borrow may start accruing interest right away. Credit card issuers also typically charge fees on cash advances, which could be a flat fee or a percentage of the cash advance amount.
Pros & Cons of Installment Loans
Installment loans are typically pretty easy to manage. Because they have a fixed term and typically a fixed rate, you generally know precisely how much you owe each month, which can make budgeting easier. But because installment loans tend to be used on bigger-ticket items like homes and cars, installment loan monthly payments could be significantly higher than monthly payments on a line of credit.
Another downside to installment loans is that, if you need more money after taking out the loan, you can't get additional funds without applying for a new loan. Plus, depending on the type of installment loan you get, there could be restrictions on how you can use the funds of that loan.
Pros & Cons of Lines of Credit
Opening a line of credit gives you the flexibility to borrow money only when you truly need it—and to continue borrowing and repaying without re-applying as long as the line of credit is active and in good standing. Plus, you can use the money you’re borrowing for most any reason.
But lines of credit often have higher interest rates than installment loans, and variable interest rates are more common with lines of credit, which could make the amount of interest you have to pay greater than what you anticipated. Because it’s considered revolving credit, a line of credit also affects your credit utilization ratio, which an installment loan does not. If this ratio is too high, it could adversely affect your credit score. Lines of credit may also come with additional fees that installment loans don’t have, including but not limited to annual fees, maintenance fees, and transaction fees.
So, Which is Better—a Loan or Line of Credit?
If you need money to pay for a one-time expense, such as a wedding, car repair, a college education, or a medical bill, and you have a good idea of how much you want to borrow, a basic installment loan may be the best option.
However, if you want money for ongoing expenses, or you're not sure how much money you’re going to ultimately need to borrow, a line of credit may be a better choice. For example, if you're planning a major home renovation, it could be difficult to estimate precisely how much it will cost to pay for all the materials you need to complete the project. A line of credit may give you the flexibility to borrow what you need, when you need it.
No matter which option you choose, the lender will decide whether you qualify by reviewing multiple factors, including but not limited to your credit history, income, credit utilization ratio, and debt-to-income ratio to determine your creditworthiness. So, before applying for any type of loan, it's a good idea to first make sure you have all of your financial “ducks” in a row to help increase the likelihood of being approved and hopefully getting more favorable terms and interest rates.