For many individuals, the prospect of taking on a personal loan or a personal line of credit can seem daunting, counter-intuitive or even shameful; moreover, both financial products are different types of loans, and it’s easy to get the two confused.
A personal line of credit and a personal loan are both options for refinancing debt, financing future expenses and achieving financial goals, when using savings may not be preferable or feasible. The main difference between a personal line of credit and a personal loan is that a line of credit enables you to borrow incrementally, while a loan gives you a lump sum of cash all at once.
There are plenty of other nuances between the two options, and it's helpful to understand how each one works before choosing.
Personal line of credit
A personal line of credit is a set amount of money from which you can borrow, up to the limit, for a given period of time, referred to as your draw period. It can be a good way to ensure that you have access to funds for anticipated and unanticipated expenses.
Generally, a borrower can use a personal line of credit to cover a range of personal expenses; these might include family planning, covering home expenses and refinancing expensive student loans at a lower interest rate.
With a line of credit, you take from the available balance only the amount you need during the draw period, and interest only accumulates on what you borrow.
A line of credit is often revolving, which means that as soon as the debt is repaid, you can borrow up to your credit limit again without going through another loan approval process. For a non-revolving line of credit, the account is closed when the credit line is paid off.
Secured or unsecured
Personal lines of credit may be secured or unsecured. If it’s unsecured, qualification depends on your income, expenses and credit history, including credit report and credit scores. If it’s secured, it also depends on your income, expenses and credit history, as well as collateral you put down, such as real estate property and cash you have tied up in investment accounts. Note that a personal line of credit is a different type of product than a home equity line of credit (HELOC), which is a loan based on your home’s value beyond what you owe on it.
How to access the money
There may be several ways the borrower can access the funds, depending on the lender’s policies during the draw period.
A lender may provide you with special checks that you can write against the line of credit or a card that works like a credit card. Some lenders may have physical “branch” locations where you can withdraw the funds in the form of cash.
Another option is to use a lender’s online platform. With an electronic transfer, you can shift money from the line of credit into your checking or savings account. It's a safe and immediate way to access the funds.
After tapping into the credit line, the lender will send you a statement with a minimum payment and due date. That amount will fluctuate based on the amount you borrowed. Depending on the lender, payments may be interest-only or encompass principal and interest. Each time you make a principal payment, your account will be credited, and you’ll have more access to the line of credit.
For lines of credit that have a repayment period, once the draw period ends, the repayment period with fixed monthly payments begins. If you owe a significant amount, those payments may be significantly higher than what they were during the draw period.
Depending on the issuing lender, there may be a variety of fees associated with the line of credit.
- Annual maintenance fee. This fee ensures the line of credit is available during the draw period. It may be charged on an annual basis or broken up into monthly increments, and is added to the balance.
- Transaction fee. Although not common, some lenders charge a small fee each time the borrower makes a withdrawal.
When weighing your options across different financial institutions, it’s worthwhile to ask the lender about fees, so you can make an informed decision. First Republic’s Personal Line of Credit, for example, does not have prepayment, origination or maintenance fees. Learn more here.
Broadly speaking, lenders will determine your borrowing limit and personal line of credit interest rate based on several factors, such as your credit score, income and existing debt. If your credit score is in the good or excellent range, the interest rate will likely be lower. If the personal line of credit is secured, collateral is also considered and can lower the interest rate.
When weighing your borrowing options, look closely at whether an interest rate for a given financial product is variable or fixed: Interest rates on personal lines of credit are usually variable, which means they’re connected to an index, such as the prime lending rate. Since the rate can fluctuate, the borrower can find themselves paying more in interest than they expected, in certain market conditions. A fixed interest rate on a personal line of credit account may offer a borrower more certainty: they can anticipate what they will be paying in interest and plan for future goals accordingly.
A personal line of credit is useful for many expenses. In particular, it can be used to cover large costs such as to:
- Refinance your student loans
- Cover home expenses
- Buy or refinance a car
- Pay for medical or dental procedures
- Family planning, such as adoption or fertility treatments
- Private K-12 schools and education expenses
If you know you’ll need a large sum of money all at once to cover something necessary that you want to pay over months or years, an affordable personal loan might make sense.
All loans have payment terms, which is a fixed time period in which the borrower must repay the principal plus interest and fees charged by the lender. Each time you make a payment, the balance is reduced until you are eventually at a zero balance.
Secured or unsecured
Like personal lines of credit, personal loans can be unsecured or secured. If it’s unsecured, qualification depends on your capacity and creditworthiness. If it’s secured, qualification also depends on the collateral you put down.
How to access the money
After the loan is granted, the lender will transfer the funds into your deposit account, and you can use the money for its intended purpose. Alternatively, if you took it out specifically for debt refinancing, the lender may send the funds directly to your creditors.
Since this is an installment loan, your payments will encompass both principal and interest, and will remain constant each month, though you can pay more to expedite payoff.
In addition to interest charges, other fees may be associated with the loan.
Some lenders will charge an origination fee to grant the loan. You would either pay it upfront or have it added to the balance. There may also be a prepayment penalty, although this is more common to mortgages or business loans, rather than personal loans; if a borrower pays the loan off earlier than the set term, the lender may charge a penalty to offset for lost revenue. First Republic does not charge a prepayment penalty for its Personal Line of Credit borrowers.
Every lender has its own set of criteria when determining interest rates for personal loans; generally, the more positive your credit history, the better the rate will likely be, especially for lenders who price their products based on credit risk. Loans with shorter terms may have lower interest rates, because the financial institution assumes less lending risk, but this isn’t always the case.
Moreover, the interest rates on personal loans can be fixed or variable over the duration of the term. Since terms can vary across financial institutions, don’t be afraid to ask detailed questions before you commit.
Personal loans are most frequently used to finance expected goods and services, such as:
- Home repairs and remodels
- A wedding or honeymoon
- Moving expenses
Navigating personal finances can be a complicated process, but you don’t have to go through it alone. Personal lines of credit and personal loans have their unique advantages, and you may require one or both to get to the next milestone in your life. Do your research, ask the right questions and choose the lending partner that will give you peace of mind and flexibility to reach your personal and financial goals.