Line of credit vs. loan: Which suits your needs?

Young parents riding city bus and debating line of credit vs. loanImage: Young parents riding city bus and debating line of credit vs. loan

In a Nutshell

The choice between a line of credit and a loan depends on your particular situation. A line of credit might be the way to go if you think you’ll need funds for various reasons both short term and long term. But a loan could be better if you need money for a specific purpose and prefer the stability of a fixed repayment schedule.
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Lines of credit and personal loans are two popular and widely available choices for borrowers, but which is the right pick for you?

The answer depends on your present and future borrowing needs, your overall credit picture and the specific credit line or loan product you’re looking at.

We’ll run through some of the key differences between lines of credit and personal loans, and explore how those specifics might figure into which one is best for you.

The key differences between a line of credit and a loan

Lines of credit and loans have some similarities, but there are several key differences, such as the repayment schedule and how often you can draw the funds.

Basic structure

A line of credit allows the borrower to draw funds up to a preset limit. Lines of credit offer a lot of flexibility — you don’t have to take all the money available to you in a lump sum, so you can borrow money only when you need it. You also don’t have to apply for a new loan if you need more money later. Instead, you can use your available line of credit for a new withdrawal up to your preset limit. When you repay any portion of the funds, they become available to borrow again if needed.

Loans are structured a little differently. With a loan, the borrower receives a lump sum from the lender and agrees to pay it back over a preset time period. If you want to change the loan amount or the length of the repayment period, you may need to apply for a new loan.

Paying interest

With a line of credit, you pay interest only on what’s been borrowed, not on the entire amount available to you. This is different from a loan, where you receive — and are charged interest on — the outstanding amount.

If your lender approves, the monthly minimum payments on a line of credit could consist of only interest. That may sound nice — it makes your monthly payment obligation minimal — but it’s also dangerous. If you continue to borrow, paying only the interest can be a recipe for getting into serious debt.

With loans, the monthly payments consist of principal (the amount you’ve borrowed) and interest, which could make for a more demanding monthly payment obligation.

Repayment periods

A line of credit doesn’t need to have a defined repayment period (that’s up to the lender). If there’s no defined repayment period, you can pay off a line of credit in as much or as little time as you want, as long as you make your minimum monthly payments. Just keep in mind that the longer you take to pay off a line of credit, the more interest charges will accrue.

Personal loans usually have to be paid off in six to 60 months, depending on the time period specified in the loan agreement.

When to consider a line of credit

A line of credit is worth considering when you need to borrow money for several reasons over a short or long period of time. The revolving nature of the line of credit means you can borrow and repay funds as needed.

For instance, if you have credit card debt you’d like to consolidate but also may need to borrow more in the coming months, you might consider taking out a line of credit. The line of credit could allow you to pay off the existing credit card debt (at a potentially lower interest rate) while freeing up the ability to borrow for an unexpected repair, for example.

Likewise, if you’re planning to borrow money for ongoing home renovations that could end up being more or less extensive than you think, the flexibility of a line of credit might be ideal.

Be careful, though: A line of credit requires discipline. If you think it might be hard to limit yourself to necessary withdrawals only, the open-endedness of a line of credit could be a dangerous choice.

When to consider a loan

Personal loans are typically a good option for covering specific expenses, or for borrowers who want the stability of a fixed repayment schedule.

Loans can be ideal for one-time needs and expenses. For instance, if you have credit card debt you want to pay off, and you don’t anticipate needing to borrow again any time soon, a personal loan could make sense. It also could be the right choice if you need to pay for an emergency car repair or another sudden expense.

Similarly, if you’re in debt because of past missteps and you’re afraid you lack the discipline to handle revolving credit, a loan could be an attractive option. In this case, the limitations on what and how you borrow, and the certainty of a set repayment plan, could provide some welcome structure.

Bottom line

Lines of credit and loans have different features and frameworks. Whether one or the other is a good fit depends on the borrower and the terms of the credit line or loan product.

Carefully consider your current and future borrowing needs — and your spending habits — before deciding which option is best for your situation.

About the author: Sean Cooper bought his first house when he was just 27 and paid off his mortgage at 30 in 3 years. An in-demand personal finance journalist, money coach and speaker, his articles have been featured in publications suc… Read more.