Personal Loan vs a Line of Credit
Which is Right for you?
With so many borrowing options available, working out which is the best one for you can be really tricky. Understanding the advantages and limitations of each option can help you to decide which one suits your situation.
We take a look at two of the most popular loan options available — personal loans and lines of credit — and explore how they work and reveal their pros and cons.
How a personal loan works
When you apply for a personal loan, you receive an up-front, one-off payment that is typically for a specific purpose, such as to pay for renovations, a new car or a vacation. Many personal loans are unsecured, which means you don’t have to put up an asset as collateral.
You start paying interest immediately, on the full loan amount, and will have fixed monthly payments until the loan is fully paid off. This is typically after an agreed number of years (the loan term). Occasionally, personal loans offer variable rates, so your monthly payment could go up or down at any time over the term.
Advantages of personal loans
- They make budgeting easy, as you know how much you need to pay every month.
- You have a set period of time after which the loan is paid off in full.
- You can take out a personal loan for a wide variety of purposes.
- If your credit is good, interest rates can be as low as 5%.
- Some personal loans allow you to pay them off before the term is up, with no penalty.
- You may be limited to how much you can borrow.
- There is no flexibility with repayments: you have to make your set payment every month.
- You start paying interest on the full amount immediately, even if you don’t use it all at once.
- Interest rates are typically higher than home equity lines of credit.
- If you have a poor credit score, you may not qualify or only qualify with a high interest rate.
How a line of credit works
There are a couple of types of lines of credit: secured and unsecured. They can be secured against assets, such as investments, or your house (in which case it would be a home equity line of credit, or HELOC for short). HELOCs usually offer the best interest rates, followed by secured lines of credit. Unsecured lines of credits typically have the highest interest rates.
With all lines of credit, your lender determines how much they are willing to lend to you and then make that whole amount available to you. You can then withdraw as much as you choose, for pretty much any purpose, up to the agreed amount.
It is similar to a credit card, insofar as when you pay off an amount, that amount becomes available for you to borrow again. Minimum monthly payments are usually interest only or a set monthly minimum amount, otherwise, you can pay off as much or as little as you choose.
Benefits of lines of credit
- Interest rates, especially for HELOCs, can be among the cheapest forms of borrowing.
- You have a lot of flexibility in how you pay off the debt.
- You only pay interest on the amount you use, not the whole amount available to you.
- You can often borrow large amounts with a HELOC.
- Money is available for different purposes, without you having to re-apply.
- You can often qualify for a HELOC even if you have a less-than-perfect credit rating.
Drawbacks of lines of credit
- If it’s secured against your home and you can’t make payments, you may lose your home.
- Most lines of credit come with variable interest rates, which can make budgeting more of a challenge.
- You need more discipline to pay it off, as you only need to pay the minimum monthly amount.
- Carrying a balance that is close to your credit limit could negatively impact your credit score.
- There can be a temptation to use your available credit as an ATM and use it to pay for things you don’t need.
- To set up a HELOC, you may have to pay closing costs.
So, which is right for you?
Personal loans may be the best option if you struggle to manage debt, have a specific reason to borrow money and want to ensure that you pay it off in a set period of time.
Lines of credit would be a better option if you know you will have a variety of credit needs over the course of a number of years, need flexibility in repaying it and want the lowest possible rates.