When you compare two different products, you might just want someone to tell you which is the best option so that you can buy it and move on with your life. However, when it comes to debt products, such as personal loans or lines of credit, the best choice varies from person to person. That is why you need to understand the pros and cons of each option, so that you can choose wisely.
If you’re choosing between a personal loan and a line of credit, we’ve got you covered. Here’s what you need to know about each of them.
Related: Compare personal loan rates
What is a personal loan?
A personal loan is a method of financing that you can use for a variety of expenses, such as renovating your home, paying for a wedding, or consolidating high interest credit cards. They are usually unsecured, which means that there is no collateral to support the loan.
The best personal loans generally have limits between $ 1,000 and $ 100,000, depending on the lender and your creditworthiness. You will receive your funding as a lump sum and pay it back in fixed monthly installments, typically for two to seven years.
When to choose a personal loan
The different types of personal loans are commonly used to cover expenses such as emergencies, unexpected bills, home improvement projects, auto repairs, and even debt consolidation. You should get a personal loan when you are sure how much to borrow.
For example, if you know you need to borrow $ 20,000 for a wedding, choose a $ 20,000 personal loan. If you’re not sure what you’ll need and have a rough number, a line of credit may make more sense.
What is a line of credit?
A personal line of credit is more like a credit card than a personal loan. When you apply for a line of credit, the lender will approve you for a certain amount, usually up to $ 100,000, with some lenders offering up to $ 500,000. Instead of receiving the amount as a lump sum, you can withdraw this amount as needed. You only pay interest on the amount you borrow, and you will pay off your balance in fixed monthly payments.
When to choose a line of credit
A line of credit is a good choice if you want more leeway and a rainy day fund to pay for occasional expenses. Common uses include emergency spending, long-term projects, education spending, cash flow management, and debt consolidation.
Because you will be given a limit rather than a lump sum, you can use as much or as little of your limit as you need. For example, if you open a line of credit with a limit of $ 30,000, you can use all of the $ 30,000 or only part of it.
Personal loan and line of credit: main differences
The limits for unsecured lines of credit are higher than those for personal loans. While some banks offer limits of up to $ 100,000, you can find lines of credit of up to $ 500,000. The maximum amount available on a personal loan is usually between $ 50,000 and $ 100,000.
Interest rates on personal loans are generally fixed, ranging from 3% to 36%. The rates are determined based on your creditworthiness, which means that if you have good credit and a stable job, you can get a better rate. However, if your score is damaged, expect to receive a rate at the higher end of the range.
Conversely, a line of credit generally has a variable interest rate, which fluctuates with the prime rate. If the prime rate increases, the interest rate on the line of credit will also increase. Borrowers can expect rates of at least 10%.
Lenders may charge an origination fee when you take out a personal loan, typically between 1% and 8%. Try to find a lender with the lowest set-up fees, or none if possible.
An unsecured line of credit, on the other hand, can include an annual fee during the drawdown period. These fees are generally $ 100 or more. Some lenders will waive the fee in the first year.
Both funding methods typically charge late fees.
Minimum credit score requirements
Lenders often have higher credit score requirements for lines of credit than for personal loans. For example, borrowers should aim to have a minimum credit score of 670 when applying for a line of credit. However, there are personal loans that only require scores of at least 580. Keep in mind: a higher credit score can offer you more favorable terms.
Term of office
Most personal loans have a term of two to seven years and repayment begins after the lender has disbursed the funds.
A line of credit, on the other hand, has two distinct conditions: the drawdown period and the repayment period. During the drawdown period, which is typically between five and 10 years, borrowers can access the line of credit up to the limit and are required to make minimum payments.
When the drawdown period ends, the repayment period begins. During this period, which varies by lender, borrowers will not be able to withdraw money from the line of credit and will have to repay the outstanding loan principal and accrued interest on a fixed date set in the loan agreement.
When you initiate a personal loan, repayment begins immediately and lasts until you repay the loan in full. With a line of credit, however, you will make minimum payments during the drawdown period and pay off the remaining balance (including interest) during the repayment period. If you haven’t drawn funds, you won’t get any payment.