Unless you’re one of the few lucky ones, there will be a time in your life when you have to borrow money. It could be that you want to make some renovations or repairs on your home. Or, maybe you’ve had unexpected medical costs, or a large car repair. Whatever the reason, you need to make the right choices as a borrower.
Most people take out either a line of credit or a loan. Your choice will depend on your specific situation at the time. While they both give you access to funds that you must pay back, they function differently. You need to understand this difference when you are applying.
A loan works by providing you with funds in a lump sum. Interest starts accumulating immediately on the entire amount, and you are responsible for paying it all back. Usually there’s a fixed schedule for payments, like the number of months and the number of payments.
A line of credit is slightly different in that you are provided access to the funds up to the limit. How much you use at any one time is up to you. If you only use $2000, then you are only responsible for that amount. If you reach your limit, then you can no longer access the funds. It works very similarly to a credit card. When you pay it down, you can access those funds again.
Personal Loans
In general, personal loans are used for 1 time expenditures. You get your lump sum, you pay for what you need, and then you begin paying it back. They are useful for things like paying for a wedding, consolidating debt, paying for a vacation, or making a large purchase. Your payments with a loan are usually fixed, which means they are a certain amount over a certain period of months. Some lenders will allow you to pay a loan off early, but some will not. You can budget around your payments easily because they will be the same amount every month.
Personal Line Of Credit
A personal line of credit is what’s known as a revolving line of credit. It’s unsecured, and in most cases has a variable interest rate. This is a good option when you are unsure how much you are going to spend, or if there is the possibility that the costs will be lower. For example, you don’t want to pay interest on a lump sum if you only needed half of it in the first place. Most financial institutions offer them, and you can also get a personal line of credit online. They are good for paying for home repair or renovation projects, to keep in reserve for emergencies, or even to cover you if your employment isn’t stable.
Similarities
While they seem very different, there are some similarities with the two lending options. For instance, they both require a credit check, and they both require the same rigorous examination of your credit and have similar requirements for borrowing. You will pay interest in both cases, and they are both unsecured. This means that you don’t have to put up an asset as collateral, such as your home. This means that you have less risk with these types of borrowing options.
Differences
Of course, there are differences between the two, and they revolve around how the funds are distributed and how you pay them back. With a loan, everything is fixed. You are given a lump sum, and then you have a certain number of months to pay it back. You know how much interest you will pay over the life of the loan.
With a line of credit, it gets more complicated. The interest rates for lines of credit are usually higher, because the lender is taking on additional risk. Not only that, but you are often subjected to a variable interest rate. This means that the rate could fluctuate, while a loan has a fixed interest rate.
The Big Question: How Do You Know Which Is Right For You?
Choosing between a line of credit and a loan will depend on a couple of factors. You’ll need to know how much funds you need, and you’ll need to assess your personal situation. Then you’ll have to weigh the pros and cons of each to make a decision.
For instance, if you’re unsure of how much you will need to use, then a personal line of credit would be appropriate. It comes in handy if your home renovation project ends up going under or even over budget. You will only pay interest on what you use. Usually, the monthly payment is based on the rate however, so you’ll have to get used to not knowing what your payments will be, as they could rise or fall unexpectedly.
A personal loan is perfect for most purchases. You pay up front, and then make the payments. There is no ambiguity with payment amounts or interest rates. This is a great option for large purchases, Christmas gifts, or even that sunny vacation.
It’s important to understand the parameters of the borrowing products that you are using. While both a line of credit and loan serve the same basic function, knowing the differences can help you make an informed decision that will save you money in the long run.
