Things that sound similar but are actually quite different: bananas and banana peppers, hops and hopscotch, dual and duel… personal lines of credit and personal loans.
That last pairing is particularly confusing. After all, both allow you to borrow money. But what are the differences between the two credit products and how do you know which is right for you?
What Is a Personal Line of Credit?
• It has a maximum credit limit.
• A minimum payment is required every month.
• When the debt on the credit line is repaid, money can be withdrawn again.
Although a personal line of credit doesn’t include a physical card, it’s still possible to write checks, withdraw cash at an ATM, and transfer money into another account. Also, unlike a credit card, you’ll likely pay less interest on a line of credit as there are predetermined terms in place.
Personal lines of credit may be secured—requiring collateral—or unsecured—not requiring collateral. For example, a home equity line of credit is secured. This is a very popular option, so much so, that it’s often referred to by people in the know by its acronym alone—HELOC.
Whether secured or unsecured, some lines of credit require minimum payments of interest and principal, while others only require interest payments for a period of time. This is known as the draw period .
That means that for a certain period of time, which could last up to 20 years, you can draw money from your line of credit and most borrowers are usually required to make interest payments.
After the draw period is over, the line of credit is no longer revolving (meaning, you can’t borrow against it anymore), and you’re required to make interest and principal payments over anywhere from a few years to 10 or 20 years. HELOCs typically have variable interest rates and may have annual fees, so they definitely aren’t for everyone.
What Is a Personal Loan?
Personal loans, on the other hand, require complete withdrawal of borrowed money in one lump sum and immediate payments toward principal and interest. This can come in handy for situations like making big purchases or paying off major medical bills. Unlike personal lines of credit, unsecured personal loans are not revolving—once the loan has been paid back, money can’t be borrowed again from the same personal loan.
Personal loans are also not revolving, which means that you cannot borrow money again from your personal loan after you pay it back.
Pros of Personal Lines of Credit
The main benefit of opening a line of credit is that there’s typically greater flexibility when it comes to accessing the loan and repaying it.
If you’re planning to do a home renovation, for example, you may not need a big chunk of money all at once. A line of credit allows you to access money over time (versus all at once) to pay for things in dribs and drabs as you pick out the tile for your kitchen and your contractor finally gets around to installing it. This flexibility can reduce your interest charges because you are only borrowing money you plan to use immediately.
Another benefit of a line of credit is that you can pay it off and then typically borrow from it again. This makes it a great backup to have in case you suddenly experience an expensive emergency that you don’t want to put on your credit cards.
You can also choose a line of credit with a draw period (similar to a HELOC) that allows you to only pay interest on the money borrowed for a period of time.
Cons of Personal Lines of Credit
One drawback is that it can be difficult to get an unsecured line of credit with a good interest rate because they can be more difficult to qualify for. This is because lines of credit are unsecured loans, and therefore, more risky for a bank. Without collateral, the bank needs to be sure that the borrower has the ability to pay back their loan. That’s why so many people have a home equity line of credit—but it means that you’re jeopardizing your home if you fail to repay it.
Also, the flexibility that comes with a line of credit may be a double-edged sword. The ability to keep borrowing or an extended period of time could lead to feeling tempted to take on more debt or take longer to pay off debt… all of which could mean more interest charges over time.
Which Option Is Best for You?
Before deciding which type of credit product to apply for, it may be a good idea to map out a plan for using and repaying the money. Also, there’s the option of applying for both, to use in different situations.
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