Welcome to the Credit Wizard’s breakdown of a loan vs. a line of credit.
You’re looking to acquire some money through a loan or line of credit so that you can accomplish some major life goals and aren’t quite sure how to go about it. A loan and a line of credit are both valuable tools that can add to your deck of financial resources.
When you have cash available to you, you’re able to set things up for yourself that can help you accomplish a few of your ultimate goals. Whether you’re looking to prepare for your late 20s, get your first car, or start investing in your dream home, these tools can be of tremendous help.
Both a loan and a line of credit are major responsibilities that you should feel prepared to take on. Learning the ropes and knowing where you stand financially are excellent first steps in working towards your future vision.
Let’s get you acquainted with loans and lines of credit so that you can understand their similarities, differences, and which would work best for you.
What Is a Loan?
We all know what a loan is; you borrow money from your mom, sister, or best friend out of good faith and eventually return it. You might even buy your lender a coffee or take them out to dinner to thank them for their generosity. If only banks could be so cool about it.
Life’s not as simple when you get a loan from a financial institution; they’re not cool with just a payback coffee. Financial institutions charge interest on the money that you borrow. For example, if you’re given $100 under a 10% interest rate, you’ll return $110 back to them ($100 + ($100 * .10) = $110).
Typically, you won’t pay a loan back within a few weeks, and you can even hold it for several years. You’re charged an APR (annual percentage rate) on top of your initial loan. An APR is your interest rate plus any fees that come with banking (finance charges).
What Happens When You Get a Loan?
When approved for a loan, you’re given one lump sum of money known as the principal. You’ll start paying interest on the loan immediately, regardless of when you actually make a withdrawal and put it to use.
If you’re going to take out a loan, you should always have a plan for paying it back as quickly as possible. Avoid paying more interest over time and being faced with extra finance charges.
If you’re a good sport about paying your bills on time, a loan should earn you a few points on your credit history and diversify your credit mix a bit.
What Is a Line Of Credit?
Now that you’re familiar with the function of a loan let’s talk about the loan’s half-sibling, a line of credit (LOC).
Simply put, a line of credit is a set amount of money that a financial institution (like a bank or credit union) gives you access to. Typically, you can make withdrawals on this amount over a given period of time (a draw period).
There are different credit lines; personal, business, and home equity lines of credit, with differing terms; secured vs. unsecured or open-end vs. close-end.
Extra Credit: Go check out What You Need To Know About Lines of Credit for the nitty-gritty details.
You can use a line of credit for various circumstances; emergencies, home improvements, or other big purchases. When you secure a line of credit, you can plan out how you’d like to use it and borrow the money when you feel it is best.
What Happens When You Get a Personal Line of Credit?
The great thing about lines of credit, particularly open-ended ones, is that you can make several withdrawals over time. For example, if your LOC is for $5,000, you can withdraw $500, pay it back and then have a total of $5,000 to draw from again.
You’re only charged interest on the money that’s borrowed, when it’s borrowed.
Having a line of credit is super helpful because it gives you access to funds you may need over time and diversifies your credit portfolio (or credit mix).
Personal Loan vs. Line of Credit
What Are The Key Similarities?
Personal loans and lines of credit are pretty gosh darn similar. It’s always best to talk through your credit history, financial goals, and what you’re looking for with a financial advisor before deciding on what route to take.
Line of credit vs. loan similarities:
- Both give you access to a sum of money to put towards something in your life plan.
- Both will charge you interest.
- Both impact your credit score: You can diversify your credit mix and manage payments.
What Are The Key Differences?
Although lines of credit and loans have their similarities, there are key differences between the two that you should be fully aware of.
Line of credit vs. loan differences:
- Open-end lines of credit let you make new withdrawals as you repay outstanding balances, whereas loans give you one lump sum to use.
- Loans charge interest as soon as you’re approved, whereas, with lines of credit, you get charged interest on what you borrow and when.
- Lines of credit tend to be more flexible and are used for several circumstances, whereas loans are typically granted to complete one task (pay for school or buy a home).
Credit Wizard Conclusions
When it comes down to it, a personal line of credit vs. a personal loan is a personal matter. It is not so personal that you should keep the debate to yourself, but personal in that it depends on your circumstances.
Always consult with friends, family, financial advisors, and the Credit Wizard before signing up for anything that will impact your financial situation.
It’s always best to avoid making financial decisions that will hurt you in the long run, so think wisely before jumping into a loan or line of credit that you don’t necessarily need.
If you’re simply looking for a way to improve your credit score, we recommend that you take a different approach. Consider re-evaluating your budget or registering for a credit-building debit card, and see where it can get you.