When it comes to paying for big life expenses such as a home improvement project, or a wedding, credit reigns supreme compared to cash. Not only is credit a more seamless form of payment that can come with perks, but it comes in different forms too, which means you’ve got options.
Two forms of credit that can help you reach your financial goals include a personal loan and a personal line of credit. Even though they may sound similar, a personal loan and a personal line of credit work differently. Each option can be a good way to borrow money, but the best option for you depends on your unique financial needs and habits.
Personal loan vs. line of credit
Personal loans and lines of credit are types of financing that can provide you with the funds you need from a lender. To get started, you need to understand what each of them is and what makes each of them unique.
What is a personal loan?
With a personal loan you can borrow a lump sum of money from a financial institution such as a bank, credit union, or online lender. You’ll then pay it back in fixed monthly installments over the course of the loan term. A personal loan can be a good choice for you if you have a large, one-time purchase or expense. Since personal loans typically have fixed interest rates and agreed upon repayment periods, your loan payment will be the same each month.
Here’s a short list of some common uses of personal loans:
- Paying down credit card debt or consolidating debt
- Financing a large purchase, like a home
- Paying for big events, items, or projects with a fixed price (wedding, home repair, student loans)
What is a personal line of credit?
A personal line of credit is similar to a credit card in that it is revolving credit. That means you can take out funds up to a set amount, pay down the balance, and borrow again when the need arises. If you need funds for a project or an expense, but aren’t sure how much it’ll cost in total, then a personal line of credit could be a good choice.
Your payments might change with time since lines of credit have variable interest rates, but you’ll only be required to pay interest on the amount of the credit that you use.
Here’s a short list of some of the best uses for a personal line of credit:
- A big project, like a home improvement project
- Emergency expenses
- Temporary income supplement
Similarities between a personal line of credit and personal loan
Let’s check out some of the more important similarities between these two forms of credit.
When you use funds from a personal loan or a personal line of credit, you’ll be required to pay back the lender for the amount you borrowed. A part of that payment will be interest, no matter if you have a personal loan or line of credit. As a reminder, interest is a percentage of the total you borrow from your lender, which they charge you for borrowing money from them.
Most of the time, personal loans and lines of credit are unsecured, which means that you don’t need to back up your loan with collateral.
In a few individual cases, some lenders will offer loans to specific borrowers only if they are secured with collateral. That means the borrower has to agree to offer up a valuable asset, like a car, home, or boat, that they own to back up the loan. When that happens, it’s because the lender wants the collateral as an extra layer of security in case the borrower defaults on the loan.
When you apply for a personal loan or a line of credit, the lender will do a hard credit check on your current financial standing and history to gauge if you’re creditworthy (aka trustworthy enough to loan to). As a part of the hard credit check for either your loan or line of credit, your credit score will likely drop temporarily. Why does your score drop when you do a hard credit check? The main reason is that a hard credit check signals to the financial institution that you might have taken on new debt that hasn’t appeared on your credit report yet.
Differences between a personal line of credit and personal loan
While both personal loans and lines of credit have some elements in common, they have some key differences too.
When it comes to taking out a personal loan or line of credit, lenders usually require borrowers to have proof of stable income and a decent debt-to-income ratio (a history of spending within your credit limit), but that’s where the requirement similarities stop.
For personal loans, lenders usually require borrowers to know their exact loan amount upfront, which isn’t always a requirement for lines of credit.
Type of interest rate
Personal loans and lines of credit both require borrowers to pay interest, but the type of interest and amount is different for each. With a personal loan, you’ll be charged a fixed interest rate on the money you borrowed starting on the first day of the loan term, while interest on lines of credit are more flexible. We’ll explain.
The amount of interest you’re required to pay on a loan depends on the lender you select and your credit report. If you have a good credit history and credit score, lenders will likely offer you a lower interest rate since they’ll consider you less of a risk. If your credit history and score could use some work, lenders will see you as a higher risk. That means lenders could decide to not offer you a personal loan. Or if they do, it will probably come with higher interest rates.
Interest for personal lines of credit is different. Because they are flexible, they usually come with higher and variable interest rates. The variable interest rate means the rate can change with time as the market fluctuates. Also unlike personal loans, you’ll only start getting charged the interest rate when you choose to take out funds.
One of the biggest differences between personal loans and lines of credit is the way funds are distributed and repaid. As we noted earlier, personal lines of credit are a type of revolving credit, which means you can take out money from your funds whenever you choose. Any money you take out will become an unpaid balance, which will gain interest the longer it goes unpaid. As you would with a credit card, you need to make the minimum monthly payments on your unpaid balances from your line of credit.
With a personal loan, lenders distribute the funds as a single lump sum once you’re approved. Once you get the funds, you’re required to make fixed monthly payments over an agreed upon repayment term.
Here’s a visual wrap-up of the typical differences between the two types of credit:
|Differences Between Lines of Credit and Personal Loans|
|Personal line of credit||Personal loan|
|Loan term length||Ongoing||6 months – 60 months|
|Type of rate||Variable||Fixed|
|Amount maximum||$1,000 – $100,000||$500 – $50,000|
|Types of fees
*Varies depending on the lender you work with
|Application fees, annual fee, exceeding credit limit fee||Application fee, origination fee, or a prepayment penalty|
|Funding||Open access, can be collected as needed||A one-time payment to the account you select|
|Credit score needed
*Varies depending on the lender you work with
|Typically 670+||Typically 580+|
How to decide which is right for you
When it comes to choosing between a personal loan or line of credit, the right choice depends on what you want to do with the money and your financial standing. If you know exactly how much you need to borrow for your expense or project and prefer predictable monthly payments, consider a personal loan. On the other hand, if you prefer to have more flexibility and you aren’t sure about the total loan amount you may need, then a line of credit may be the better choice.
In order to qualify for a personal loan, you need a good credit score. You’ll likely need an even better credit score if you want to get a line of credit. If you have good or excellent credit already, then you’re in luck.
Can I still get a personal loan or line of credit if I don’t have a credit score?
Worried about your credit score? If you have a low credit score or no credit score at all, then it might be more difficult for you to qualify for a personal loan or line of credit, but it’s not impossible.
If you have a low credit score, you may still qualify for a loan or line of credit with a lender, but it’ll likely come with a high interest rate. If the interest rate is very high and you don’t need funds ASAP, consider taking steps to improve your credit score before you apply.
With no credit score, you have two options: find a lender that doesn’t require a credit check and uses alternative factors or take steps to quickly establish credit. Some lenders and lending platforms, like Upstart, will consider other factors to gauge your financial trustworthiness if you are new to borrowing and don’t have a credit score yet.
You can establish credit quickly with several methods. Here are top three to consider:
- Open up a secured credit card and making on-time, monthly payments
- Become an authorized user on a loved one’s credit card (someone who already has excellent credit)
- Pay all your bills on time
The bottom line on personal loans and lines of credit
Before you get started, think about how much you’ll need to borrow and for what type of project you need the funds. You need to select the option that’ll best fit your financial needs. Check your current financial standing and history to get an idea of what you’ll be eligible for.
Remember, each person is entitled to one free credit report each year, so if you need to, you can request a free credit report from AnnualCreditReport.com. Once you know your financial history and have a few quotes from lenders and lending platforms, compare them and select the one that’ll work best for you.