Personal Loan vs. Line of Credit: Which is the Right Option for You?
If you are in a financial bind and need money, you might consider a personal loan or line of credit.
While both of these financial products will get you the money that you need, they work differently. There are some cases where either will work just as well but in most cases, one will clearly be a better option.
Find out how to choose between a personal loan and a line of credit depending on your situation.
Personal Loans
A personal loan is an installment loan that you can use to meet large or unexpected financial needs at one time.
There are two types of personal loan: unsecured and secured.
Pros and Cons of Unsecured Loans vs. Secured Loans
| Unsecured Loans | Secured Loans | ||||
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Pros |
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| Cons |
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Unsecured
With an unsecured personal loan, you apply for the loan without providing any collateral.
The only assurance that you’ll pay the loan that the bank has is your word.
This means that unsecured loans can be risky for banks to make. This results in unsecured personal loans charging more interest.
Secured
Secured personal loans require that you offer some form of collateral when applying for the loan.
The collateral can be anything of sufficient value, including deposits in a savings accounts, certificate of deposit (CD), or a physical asset such as a car.
If you fail to make timely payments on a secured personal loan, the lender can repossess the collateral. This results in much lower risk for the lender, but more risk for you.
For that reason, secured loans are easier to qualify for and charge less interest.
Set amount and repayment period
When you apply for a personal loan, you request a specific amount of money and specify how long you’ll need to pay it back.
If your loan is approved, the full amount will be deposited to your account and you can spend it immediately. You’ll get a bill each month until you pay the loan off.
You’ll know when you receive the loan what your monthly payment will be and how many payments you’ll need to make to pay the loan off.
Costs
Personal loans may come with various fees, including application fees, origination fees, and prepayment penalties.
Some lenders do not charge any of these fees. However, do note if their interest rates are higher than others.
Common Personal Loan Fees
| Type of fee | Typical cost |
|---|---|
| Application fee | $25 to $50 |
| Origination fee | 1% to 6% of the loan amount |
| Prepayment penalty | 2% to 5% of the loan amount |
| Late payment fee | $25 to $50 or 3% to 5% of monthly payment |
| Returned check fee | $20 to $50 |
| Payment protection insurance | 1% of the loan amount |
Available at financial institutions and online lenders
You can get personal loans from a wide variety of financial institutions.
One of the most common places to get a personal loan is a bank or credit union. There are also online lenders who specialize in offering personal loans.
You can also turn to peer-to-peer online lenders. With a peer-to-peer lending site, regular people will fund a small portion of the loan you apply for. When you pay the loan back, those investors earn some return. In effect, you’re borrowing from regular people rather than a traditional lender.
In a sense, payday loan companies and pawn shops are also offering a form of personal loan. However, you should avoid these types of companies when looking for loans because they charge exorbitant fees.
Pros:
- Get the money you need, when you need it
- Secured personal loans are easier to qualify for than other loans if you can provide collateral
- Some lenders offer loans as large as $100,000
- Loans are customizable to your needs
Cons:
- If you have a variable interest rate, your monthly payment can change drastically
- If you need to borrow more money, you’ll need to apply for another loan
- You may have to pay origination, application, and other fees
Personal Line of Credit
A personal line of credit gives you the flexibility to get extra cash when you need it, as you need it.
Similar to a credit card
You can think of a line of credit as acting much like a credit card.
When you are approved for a line of credit, the lender will tell you how much they are willing to lend to you at once.
This is the limit for your personal line of credit.
When you need cash, you can go to the bank and request to draw money from your line of credit.
The money will be deposited into your checking account and the balance on your line of credit will increase.
So long as you carry a balance on your line of credit, you’ll receive monthly bills. These bills will tell you your current balance and the amount of the minimum payment you must make.
For borrowing whenever you need it
If and when you have a balance of $0, you’ll stop receiving monthly bills.
However, the line of credit will stay open.
If you need cash at a later date, you can go back to the bank and ask to draw more money from the line of credit.
You can even ask to borrow more money while you’re paying down the balance that you borrowed previously.
So long as you don’t exceed the credit limit that’s been extended to you, you can draw from the line of credit as often as you’d like.
Costs
In addition to the interest rate, lines of credit often have maintenance fees, to pay for the bank’s expense in keeping the line available to you.
Available at banks and credit unions
A personal line of credit is most commonly offered by banks and credit unions.
Generally, it is less likely to be found at online lenders.
Pros:
- Once the line is open, borrow from it any time
- Always available, and you only need to apply once
- Borrow exactly the amount you need
Cons:
- Limit tends to be lower than the largest personal loan available
- Maintenance fees
- Variable interest rate means the size of your monthly payment can change
Which One Should You Use?
Whether you should use a personal loan or a personal line of credit depends on your situation.
Some questions you should ask yourself when deciding are:
- Do I need one lump sum of cash or regular access to smaller loans?
- Do I want a fixed interest rate, or is a variable rate alright?
- Do I mind paying a maintenance fee?
- Do I need to borrow a lot of money or just a small amount?
If you need to borrow a lot of money in a single lump sum, you’ll want to apply for a personal loan.
You can find lenders who offer personal loans for as little as $1,000 or for as much as $100,000.
Most lines of credits won’t let you borrow $100,000 at once.
Personal loans also disburse the full amount right away, so you can use the money to meet an urgent need.
If you need to borrow a smaller amount and don’t mind paying a maintenance fee, a personal line of credit can be a good choice.
Personal lines of credit let you borrow small amounts of money, and stay open once you pay them off. That gives you the flexibility to use them again in the future, so long as you pay the fees to keep the line of credit open.
If you need regular access to small loans, a line of credit is also the best choice for you.
They give you easy access to cash whenever you need it.
That makes them great for small business owners with unpredictable costs or someone who is doing a project with an uncertain timeline and cost estimate.
Credit Score and Income Matter for Both
Whether you’re applying for a personal loan or personal line of credit, your credit score and income will both come into play.
When you apply for a loan or line of credit, the lender will look at your credit score.
Your credit score is a numerical representation of your behavior with borrowing.
The higher your credit score, the more likely you are to make your monthly payments in a timely manner. The lower your score, the higher the risk of default is.
Lenders primarily care about getting their money back.
If you have a poor credit score, you’re unlikely to get a loan or line of credit from a lender. If you do, you’ll be paying a higher interest rate to compensate for the lender’s increased risk.
To qualify for the best rates and the largest loan amounts, you’ll need a good credit score. You’ll also need to show that you have a good source of income.
Your income comes into play because lenders will also look at your debt-to-income ratio when considering your application.
This ratio is calculated by dividing your total debt by your annual income.
The lower this ratio is, the more money you have left over each month to make payments on new loans. That means a lower debt-to-income ratio looks good to lenders.
Lenders will want to see a low debt-to-income ratio, and that you earn enough money to pay off whatever loan you’ve applied for.
If you only make $5,000 each year, there’s no way you’ll get a loan for $100,000, even if you have perfect credit and a debt-to-income ratio.
You need to show that you make enough to pay the loan off in a timely manner.
Conclusion
Personal loans and personal lines of credit both offer you a way to get cash when you need it.
The right choice for you depends on your situation.
A personal loan is better when you need a one-time lump sum loan.
A personal line of credit is best for when you need multiple smaller loans over a period of time.
Wondering how much a personal loan might cost you? Check out our personal loan calculator to help you figure out your possible monthly payments and accrued interest:
