A personal line of credit is a type of revolving credit line that can be used to pay for a variety of personal expenses. This is different from a personal loan, which is an installment loan — awarded in a lump sum to the borrower that must be repaid at specified intervals.
While both options allow you to borrow money there are benefits and drawbacks of each. Continue reading for more information on personal lines of credit and when this type of financing may make the most financial sense.
What Is a Personal Line of Credit?
A personal line of credit is what’s known as a revolving credit vehicle. It’s similar to a credit card in that:
• 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• When the debt on the credit line is repaid, money can be withdrawn again.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. Generally speaking, the interest rates on a personal line of credit are lower than those on a credit card.
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.
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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 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.
Where to Get a Personal Line of Credit
Not every bank or lender will offer personal lines of credits though they can be found at some banks, banks, credit unions, and other financial institutions.
How to Get a Personal Line of Credit
The process for applying for a personal line of credit is usually similar to applying for other loans or credit cards. Lenders may accept applications online, in-person, or over the phone, and specific application requirements may vary by lender.
Before formally applying, review your credit score and shop around at different lenders to compare the rates and terms you may qualify for. Many lenders will allow you to see if you prequalify, which may require a soft credit check, which won’t impact your credit score. Also be sure to evaluate any fees associated with the line of credit and review the draw period and repayment periods.
Once you’ve determined which loan you’d like to apply for, gather the required documentation (such as statements for proof of income). Your chosen lender will generally have a list of required documents. From there, you’ll fill out the application and wait for approval. At this stage, the lender will usually complete a hard credit inquiry which may impact your credit score.
When to Use a Personal Line of Credit
Personal lines of credit typically offer greater flexibility when it comes to accessing the loan and repaying it than other types of financing like a personal loan or credit card.
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.
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Drawbacks to a Personal Line 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 than some other types of loans, such as a HELOC. This is because personal lines of credit are unsecured loans, and therefore, more risky for the lender. Without collateral, the lender needs to be sure that the borrower has the ability to pay back their loan. That’s why for some, it may be easier to qualify for a HELOC — 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 for 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.
Using a Personal Loan as a Personal Line of Credit Alternative
When comparing a personal line of credit vs a personal loan, the major difference is that a personal loan is, as mentioned, an installment loan. Like a personal line of credit, personal loans can be used to pay for nearly any personal expense. Borrowers receive a lump sum payment and pay back the loan in installments. Personal loans may have fixed or variable interest rates.
A personal loan may make more sense for borrowers who have a firm idea of their budget or a fixed expense, such as for medical bills, buying an engagement ring, or consolidating debt. Additionally, depending on creditworthiness, the average interest rate on a personal loan may be lower than that of a personal line of credit. Though interest rates will vary by lender so evaluate the options available to you.
Also compare any fees or penalties associated with the personal loan. If a personal loan has a prepayment penalty, you may not be able to pay off the personal loan early.
Other Personal Line of Credit Alternatives
HELOC. As mentioned, this is a home equity line of credit. Borrowers tap into the equity in their home to borrow a line of credit. This is a secured loan where the house functions as the collateral. This can help borrowers qualify for a more competitive interest rate than with an unsecured personal line of credit, but it also means that if the borrower has issues repaying the HELOC, their home is at risk.
Credit Cards. In certain situations, a credit card may be used to help pay for emergency expenses. Be aware that credit cards generally have high interest rates — the average credit card interest rate was 14.56% in February 2022, according to recent data available from the Federal Reserve .
Secured Loans for a Specific Purpose. For example, if you are buying a car consider a car loan over a personal line of credit or personal loan.
Personal lines of credit offer flexibility for borrowers because they are a revolving line of credit that functions similarly to a credit card. Borrowers can continue drawing on the line of credit for a set period of time to cover the cost of necessary expenses.
Personal loans are an alternative to consider for borrowers who are paying a fixed cost.
If you’re in the market for a personal loan — consider SoFi, which offers low fixed interest rates and have no fees required.
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