Which is better- a line of credit or a loan? Both have pros and cons, but which is right for you?
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. Here's what you need to know about each option to make the best decision for your financial situation.
Basic Structure
A line of credit is a great way to get funds up to a pre-determined limit when needed. You don't have to take all the money at once, so it's easy enough for your borrowing power. When you repay any portion of the funds, they become available to borrow again. In other words, you also don't have to apply for a new line later. They are pretty convenient!
Loans differ because you receive a lump sum and then have to pay back whatever balance is left at the agreed-upon time. Should your needs change meantime? You can always apply for another loan with terms that match your situation better - but be aware that there might come costs involved if it takes longer than expected or higher interest rates.
Paying Interest
With a line of credit, you pay interest only on what's been borrowed, not the entire amount available. Loans differ in where you receive — and are charged interest on — the outstanding amount.
Tip: With lines of credit, the minimum monthly interest involves only paying off the interest. Although it sounds like the lender is giving you a free pass, it can be dangerous to rack up debt.
On the other hand, loan payments consist of the principal (the amount borrowed) and interest, making it seem more demanding.
Repayment Periods
A line of credit doesn't need 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 if you make your minimum monthly payments. Remember that the longer you pay off a line of credit, the more interest charges will accrue.
Personal loans, in contrast, usually must be paid off in six to sixty months, depending on the time specified in the loan’s terms.
When to Consider a Line of Credit
A line of credit is worth considering when you need money for several purchases over a short or long time. The revolving nature of the line of credit is convenient because you can borrow and repay funds as needed.
For example: 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. It allows you to pay off the existing credit card debt (at a potentially lower interest rate) while freeing up the ability to borrow for unexpected expenses.
Likewise, if you're planning to borrow money for ongoing home renovations that you're unsure how long they will take, the flexibility of a line of credit might be ideal.
Be careful, though: If you're not careful with your credit, an open-ended line of credit can be more trouble than it's worth. Stay out of debt!
When to Consider a Loan
Loans can be ideal for one-time needs and expenses. For instance, a personal loan could make sense if you have credit card debt you want to pay off and don't anticipate needing to borrow again soon. It also could be the right choice if you need to pay for an emergency or immediate expenses.
Or, perhaps, you're in debt because of past mistakes and feel like your financial discipline isn't up to the task. A loan could be attractive if you need some structure and know that revolving credit is not the right choice for you! The limitations ensure more control when things get paid back as well since no matter what, no debts will go unpaid.
Bottom Line
The features and benefits of these two types of credit are different, so it's important to consider your needs before deciding which option is best for you.
It depends on the borrower, spending habits, and the credit or loan terms. Consider your current and future borrowing needs before deciding which option is best for your situation.