Personal Loan vs. Line of Credit: Here’s the Difference for Borrowers
Written by
Barb Nefer
Edited by
Emily Gadd
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When you need to borrow money, you have a few different options, including personal loans and lines of credit. A personal line of credit is an open-ended loan that lets you access money when you need it, similar to a credit card. When you use it, you incur interest on the amount you take out and are billed monthly for repayment. In contrast, with a personal loan, you borrow a lump sum for a set period and pay it back in installments.
Both of these options are unsecured loans, meaning they don’t require collateral. That makes them different from a secured loan, such as a car loan or a home equity line of credit, in which your property guarantees repayment. Here are more details on a personal loan versus a line of credit, so you can better decide which borrowing option is better for you.
How a Personal Line of Credit Works
With a personal line of credit, you’re approved for a set amount, similar to a credit limit. You tap into it as needed for any reason, from daily expenses to emergencies. A personal line of credit can also tide you over if you’re self-employed or work on commission and have gaps between paychecks.
You access the funds by transferring money or writing a check against your line of credit. Depending on the account terms, the bank might charge you a fee to use the credit line. You’ll receive a monthly statement showing the minimum payment and interest charges. Like a credit card, you must pay at least the minimum. Some lenders might charge other fees, including prepayment penalties.
How to Qualify for a Personal Line of Credit
Like credit cards, personal credit lines are typically unsecured loans. Financial institutions often require you to maintain a checking or savings account to qualify for a line of credit. You also need a good credit history that shows you pay your bills on time and have a low debt-to-income ratio. Your credit score plays into the bank’s decision, but there’s no standard credit score requirement across all financial institutions.
For a personal line of credit, rates tend to be high, so you’ll save if you shop around for the best interest rate.
How Personal Loans Work
A personal loan provides you with a lump sum. It’s unsecured, which means a higher interest rate because there’s no property for the lender to seize if you default on the loan.
You can use your personal loan funds for any purpose, from home improvement to paying off a higher-interest credit card to taking a vacation. You’ll pay the loan off in installments. Read the terms and conditions to understand if any prepayment penalties or other fees apply.
How to Qualify for a Personal Loan
You need a good credit score and solid credit history to qualify for these unsecured loans. You might qualify for a personal loan even if you have had financial problems, but you’ll pay a higher interest rate and be limited in the borrowing amount. Even though these loans have higher interest rates for borrowers with bad credit, personal loans are a great way to rebuild credit history if you make all your payments on time.
Differences Between a Personal Loan and Line of Credit
If you’re choosing between these two ways to borrow money, knowing what makes them distinct from each other can help you decide. Here are the main differences between the two loan types:
- A personal loan is a lump sum; a personal line of credit is used as needed.
- You only pay interest on the money used in your personal credit line, but your bank might charge a fee for this use. You pay interest on the full amount of a personal loan.
- You pay a fixed amount each month on a personal loan, whereas you only pay on a personal line of credit when you use it, with a minimum monthly payment determined by what you used.
| Feature | Personal Loan | Line of Credit |
|---|---|---|
| How You Get Money | One lump sum | Borrow as needed |
| Interest Rate | Fixed | Variable |
| Repayment | Fixed monthly payments | Flexible payments |
| Best For | One-time large expenses | Ongoing or unpredictable costs |
Pros and Cons of Personal Loans
Here are some pros and cons to consider before you take out a personal loan:
Pros:
- Monthly payments that are the same every month
- Usually lower interest rates than credit cards
- Can build your credit if paid on time
Cons:
- You have to borrow a fixed amount
- Some lenders charge fees for early repayment
- Can hurt your credit if you miss payments
Pros and Cons of a Line of Credit
Here are some pros and cons to consider before opening a line of credit:
Pros:
You only have to pay interest on the money you use
You can borrow the exact amount you need
Can be a better choice for sudden expenses from emergencies or ongoing expenses
Cons:
- Interest rates can change from month-to-month, making payments less predictable
- Can lead to overspending if not managed well
Do Personal Loans and Lines of Credit Affect Credit Score
Both have the potential to impact your credit positively and negatively.
Payment History
Both can boost your credit score if you make your payments on time — and hurt if you don’t.
Credit Mix
Depending on the other types of credit you have open, personal loans can help boost your credit mix. This is when showing that you can successfully pay off different types of debt gives you a better credit score.
Credit Utilization
Credit bureaus prefer when people have only used about 30% of their available credit. Getting approved for a new line of credit can lower your credit utilization.
FAQ
- Which has a lower interest rate, a personal loan or a line of credit?
- It can depend on the lender and your credit history. However, a personal loan often has lower interest rates.
- Can I use a line of credit like a credit card?
- Yes. A credit card is also an example of a line of credit.
- How do I qualify for a personal loan or a line of credit?
- You might find a lender who will approve your application if you have poor or fair credit. However, A good credit score will help you get lower interest rates.
- Is a personal loan or line of credit better for emergencies?
- A line of credit is often better for emergencies. This is because it often takes less time to get approved.
- Does a line of credit affect my credit score more than a personal loan?
- They can both affect your score. If you only have short-term loans on your credit history, you won't benefit from the credit mix consideration. However, the most important factor of your credit score is paying your bills on time.
