There are two main differences between a personal loan and a personal line of credit: how the loan funds are disbursed to the borrower and how the credit is repaid.
There are also some similarities. Funds from each can be used for a variety of expenses, with few exceptions. For both a personal loan and line of credit, lenders will run a credit check during the application process.
Each has its strengths, depending on what you need the money for, so knowing a few basics about the difference between personal loans vs. personal lines of credit will help you find the best fit for your situation.
What Is a Personal Line of Credit and How Does It Work?
A personal line of credit (LOC) is a type of revolving credit similar to a credit card. But funds are typically accessed by writing checks provided by the lender or requesting a funds transfer to your checking account instead of by using a card.
An LOC is open ended, so the borrower can withdraw the funds repeatedly, up to the credit limit. Any funds that are withdrawn are subject to repayment with interest. When they are repaid, they can be accessed again. There may be a limit on the number of years the line of credit is available.
Some lenders may charge fees associated with an LOC. There may be a maintenance fee for inactive accounts. There may also be ongoing fees, monthly or annual, even if the LOC is being used. Some other fees may include application fees, check processing fees, late fees, or others. It’s important to be aware of any potential fees before you sign an LOC agreement.
Personal lines of credit are usually unsecured, although you may be able to put up collateral to get a lower interest rate. A home equity line of credit, or HELOC, is an example of a secured line of credit.
Typically, a personal LOC will be offered by a bank or credit union, and you might have to have another account with the lending institution to be considered for an LOC.
If your LOC is unsecured, the interest rate will probably be variable, which means it could go up or down during the loan’s term, and your payments could vary. But you’ll only be charged interest on the amount you withdraw. If you’re not using any LOC funds, you won’t be charged interest.
If you expect to have ongoing expenses or if you have a big expense (like a wedding or home renovation) but don’t know what your final budget will be, this type of borrowing might be a useful financial tool.
A personal LOC also may be the right fit if you need some flexibility with your borrowing. For example, self-employed workers who know they’ll be paid by a client, but aren’t sure exactly when, can tap into their line of credit to pay expenses while they wait. They can pay that money back when they receive payment from the client, and they won’t have to use high-interest credit cards or borrow from other savings to make ends meet.
Of course, there are downsides to that easy-to-access money. Since unsecured lines of credit are considered by lenders to be riskier than their secured counterparts, it can be more difficult to qualify at a favorable interest rate.
And once you have access, it may be tempting to use the funds for purposes other than originally planned. Keeping in mind the intended purpose for the funds may help you stick to it and not use the funds for other purchases.
Pros and Cons of Personal Lines of Credit
Having funds that can be accessed as needed can be helpful. But there are also some drawbacks to consider.
Pros of Personal Lines of Credit
• Easy access to funds.
• Open ended.
• Minimal limits on use of funds.
• Can be useful for ongoing expenses.
Cons of Personal Lines of Credit
• May have a higher interest rate than other forms of credit.
• Typically are unsecured, so may be more difficult to qualify for than other forms of credit.
• Interest rate may be variable, presenting a budgeting challenge.
• Ease of access can be tempting to use for unintended purposes.
What Is a Personal Loan and How Does It Work?
A personal loan is a fixed amount of money disbursed to the borrower in a lump sum. If the loan has a fixed interest rate, as is typical for personal loans, the payments are in fixed installments for the term of the loan. If the loan has a variable interest rate, the monthly payments may fluctuate as the interest rate changes in accordance with market rates.
Because personal loans typically have lower interest rates than credit cards, they’re often used to pay off other debts such as home and car repairs or medical bills, or to consolidate other higher-interest debts such as credit card balances into one manageable — and potentially lower — monthly payment.
A personal loan can be a useful tool for debt consolidation. If you can qualify for a personal loan that has a lower interest rate than your other outstanding debts, you may be able to save money in the long run by consolidating those debts. In order for this financial strategy to work, it’s important to stop using the old sources of credit to avoid going deeper into debt.
A personal loan also could be a suitable choice for paying for a wedding or home renovation. But it’s important that you feel confident about being able to repay the loan on time and in full. If you don’t responsibly manage a personal loan — or any kind of debt, for that matter — your credit can be adversely affected.
You can apply for a secured or unsecured personal loan. A secured loan, which is backed by collateral, is typically considered less of a risk by lenders than an unsecured loan is. Collateral is an asset the borrower owns — a vehicle, real estate, savings account, or other item of value. If the borrower fails to repay a secured loan, the lender has the right to take possession of the asset that was put up as collateral.
An applicant’s overall creditworthiness will be considered during the approval process. Generally, an applicant with a higher credit score will qualify for a lower interest rate, and vice versa.
Some lenders charge personal loan fees such as origination fees or prepayment penalty fees. Before signing a loan agreement, it’s important to be aware of any fees you may be charged.
Pros and Cons of Personal Loans
When you need a set amount of money for an expense, a personal loan can be a good choice. Along with the benefits of using this financial tool also come a few drawbacks to consider.
Pros of Personal Loans
• May be a good choice for large, upfront expenses.
• Typically have fixed interest rates.
• Steady payments may be easier to budget for.
• May have a lower interest rate than credit cards.
Cons of Personal Loans
• Unsecured personal loans may have higher interest rates than other forms of secured credit.
• May need a higher credit score to qualify for lower interest rates.
• If not used responsibly, it can add to a person’s debt load instead of alleviating it.
• May have fees.
Major Differences Between Personal Lines of Credit and Personal Loans
When you’re looking for the right source of funding for your financial needs, it can help to compare different types. Here are some specifics to consider when looking at personal LOCs and personal loans.
| Personal Line of Credit | Personal Loan |
|---|---|
| Typically has a fixed interest rate | More likely to have a variable interest rate |
| Fixed interest rate may make it easier to budget payments | Variable interest rate may present a budgeting challenge |
| Fixed, lump sum | Open-ended credit, up to approved limit |
| Interest is charged during entire loan term | Interest is only charged on withdrawn amounts |
| Revolving debt | Installment debt |
Considering the Type of Debt
When you’re thinking about applying for a personal LOC or a personal loan, it’s important to consider the effect borrowing money can have on your credit score. If you borrow money without a repayment plan in place, you could run into trouble no matter which borrowing option you go for. But each is looked at differently by the credit bureaus.
A personal LOC is revolving debt, which means it will factor into your credit utilization ratio — how much you owe compared to the amount of credit that’s available to you.
For a FICO® Score or a score by VantageScore, keeping your total credit utilization rate below 30% is recommended.
• Using a large percentage of your available credit can have a negative effect on your credit score. And lenders may see you as a high-risk applicant because they may assume you’re close to maxing out your credit cards.
• Using a small percentage of your available credit can work in your favor. If your credit utilization ratio is low (under 10%), it signifies to potential lenders that other lenders have determined you to be a good risk, but you don’t need to use the credit that’s been extended to you.
• Having a low credit utilization rate by using just a little of your available credit could actually have a more positive effect on your credit score than not using any of it at all. Lenders generally look for signifiers of a healthy relationship with credit.
A personal loan is installment debt and isn’t considered in your credit utilization ratio. In fact, if you pay off your revolving debt with a personal loan, it potentially can lower your credit utilization ratio and have a positive effect on your credit score. A personal loan also can add some variety to your credit mix — something else that’s calculated into your credit score.
Personal LOC or Personal Loan: Which Is Right for You?
Before you decide to take out a line of credit or a personal loan, it’s wise to compare lenders. Look at the annual percentage rate and whether it’s fixed or variable. You can also take into account any fees you might have to pay, including origination fees, annual fees, access fees, prepayment penalties, and late payment fees.
Estimating the total cost of the loan until it’s paid in full, including the principal loan amount, interest owed, and any fees or penalties you could potentially be charged, will help you figure out how much the loan will actually cost you.
The Takeaway
Deciding when and how to borrow money can be a tough decision. But once you check out the lending options available, find your fit, and are ready to go, you’ll want the application and approval process to be as painless as possible. Applying for a SoFi Personal Loan online is easy and you can check your rate in just one minute.
SoFi Personal Loans have no fees required and no hidden costs. Interest rates are fixed and there are a variety of loan terms to fit different budgets.
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