Loan vs. Line of Credit: What’s the Difference?
When you need to borrow money, your lender may present you with the choice between a loan or a line of credit. While both credit products can accomplish the same goal, they have several differences, and one is often more suitable than the other.
In this article, I’ll explain the differences between personal loans and personal lines and cover some pros and cons to help determine which is right for you.
What Is a Loan?
A loan is an amount of money that you borrow and pay back over a predetermined period. The lender advances a single lump sum to the borrower, who makes regular payments (usually monthly or biweekly) until they pay the entire loan in full. Unlike a line of credit, a loan doesn’t revolve; it must be repaid in full by a specific date.
Loans are most often used for the following purposes:
- Vehicle purchase
- Debt consolidation
- Education (Student Loan)
- Home Improvements
- Investment loans, including RRSPs
Loan amortization varies depending on the purpose of the loan, as well as the amount. For example, it’s common for new vehicle loans to have an amortization period of 84 months (7 years), although you can pay them off more quickly. On the other hand, a debt consolidation loan might have an amortization of 48 months. There are no hard and fast rules, and each lender has its criteria.
Note: Many people opt for extended amortization periods to keep their monthly payments down, i.e., new vehicle loans. The problem is that you’ll pay much more interest by taking longer to pay off a loan, you’ll pay more interest.
For example, a $40,000 vehicle loan amortized over 60 months (5 years) at 5.99% will have a monthly payment (P&I) of approximately $775.00 and a total interest paid of $6387.00.
If you take that same $40,000 loan, also at 5.99%, but spread the payments over 84 months (7 years) instead of 60 months, you’ll end up paying $9068.00 in total interest, almost $2700 more. The $584 payment might seem more manageable, but you’ll pay a lot more for the vehicle. In other words, extended amortizations are one of the hidden costs of debt.
Secured vs. Unsecured Loans
Many personal loans are unsecured – that is, they are approved based solely on the borrower’s creditworthiness. With a secured loan, the borrower must provide additional security to minimize the lender’s risk. Secured loan benefits can include lower interest rates and flexible repayment conditions. Vehicle loans and mortgages are the best examples of secured loans.
Pros and Cons of a Personal Loan
There are several instances where it makes more sense to take out a loan versus a line of credit. But loans aren’t always the best option. Here’s my list of personal loan pros and cons:
- The loan balance has a fixed repayment date
- Various uses (House, Vehicle, Education, Investment)
- Fixed monthly payments
- Choose from a fixed or variable interest rate
- No penalties for paying off early
- Ability to make additional lump sum payments
- You may have the option of deferring payment(s) in an emergency
- Not great if you don’t need all the money upfront, i.e. home reno
- Fixed payment amount lacks flexibility
- If you have to provide security, it can be inconvenient
- Unsecured loans tend to have higher interest rates
What Is a Line of Credit?
A line of credit, or credit line, is a revolving loan. The lender authorizes a specific credit limit, and the borrower draws only what they need. The full credit limit remains, so the borrower can draw more funds or re-borrow as the balance is paid down.
For example, if your bank approves you for a $10,000 line of credit, that’s your credit limit. You can spend up to $10,000, but there is no obligation to borrow any amount. You only pay for what you use. If you draw down $1000, you’ll pay interest on that amount, and the remaining $9000 is available for future use.
Unlike loans, credit lines don’t have set repayment dates. As long as you make the minimum payment on time each month, your credit line will remain in good standing. Credit cards work the same way, albeit at much higher interest rates.
While this adds flexibility, it can also be problematic. Many people lack the discipline required to pay off their line of credit in full.
Note: Many lenders have a feature that lets borrowers assign a fixed term and periodic payment amount to some or all of the balance owing in their line of credit. It’s like having a loan inside your line of credit. As the fixed portion is reduced, the amount is once again available for credit.
The minimum payments vary and are based on a percentage of the overall balance, usually between 1% and 3%. With lines of credit, as with most loans, you can pay as much as you’d like over and above the monthly payment without any penalties.
Secured or Unsecured Line of Credit
Depending on its purpose, your credit line may be secured or unsecured. A home equity line of credit, or HELOC, is perhaps the best example of a secured credit line. You can use a HELOC to purchase a home or to borrow against your existing home equity. You can also secure credit lines with investments or business assets (business line of credit).
Pros and Cons of a Line of Credit
With lines of credit, flexibility is the name of the game. You can set up a credit limit and only withdraw money when you need it.
- More convenient than a personal loan
- Access to the entire credit limit
- Access funds via ATM, web banking, or debit purchase
- Flexible payments
- Obtain credit for future use
- You can use it as an emergency fund
- Home equity lines offer maximum flexibility at low rates
- Unsecured lines have higher interest rates than loans
- Must have a higher credit score to qualify (higher risk)
- Requires discipline to pay off the balance in full
Loan or Credit Line: What’s Easier to Get?
Generally speaking, personal lines of credit are more challenging to obtain than loans, because of the revolving nature of the product. Technically, you can continually re-borrow from a line of credit up to the full credit limit. Thus, lenders assign a higher risk rating to credit lines than they do for loans. You will need a strong credit report to qualify for a personal line of credit.
Personal Loan or Line of Credit: What’s Right for Me?
Deciding between a personal line of credit or a loan is difficult. While the correct answer depends on the individual borrower, here are some rules of thumb. A loan is your best bet if you need 100% of the funds upfront. You’ll benefit from a lower interest rate and the comfort of knowing when you will fully repay the debt. You’ll also have the option of paying it off more quickly.
If you need to borrow various amounts of money over an extended period, a line of credit is probably the way to go. Take home renovations, for example. Your home reno might take up to a year to complete. Do you want to pay interest on all the money from day one (loan), or only as you need to withdraw to purchase supplies or pay your contractor?
Lastly, if you decide on a personal line, ensure you have the discipline to use it for the intended purpose. Too many people fall into the same trap with credit lines as credit cards – they can never seem to pay off the entire balance.
But if you want to use rewards for travel, you’ll get the maximum value from the AmEx Gold. You’ll…