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Personal loan vs. personal line of credit: Which is right for you?

Life happens, and sometimes you may need a little extra cash for those unexpected expenses. A personal loan and a personal line of credit are two ways to borrow money that usually don’t require collateral — but they function differently — so it’s important to understand the differences between the two types of loans.

Similarities and differences

A personal loan and personal line of credit are similar in many ways.

Similarities:

  • Both are unsecured borrowing methods, which means they don’t require any collateral.
  • They both can provide extra cash in your pocket for rainy days or known expenses.
  • Both require a hard credit check as you go through the approval process.
  • They have similar typical uses for things like debt consolidation, home improvements or even vacations.

 

Differences:

Where they begin to differ is in how they function. The main difference is how you receive or use the funds and how you repay the loan.

Personal Loan:

A personal loan provides a lump sum that you can use immediately and repay in fixed installments over a set period of time. Perhaps you have a weekend vacation coming up, but you’re short on money for the trip. Or you need to borrow money to pay for a repair to your car. These are typically used in situations where you know the amount of the loan in advance. You can even use these types of loans to consolidate higher-interest debt into one fixed monthly payment.

“A personal loan is generally going to be considered a lower liability with credit agencies because you’re borrowing it all at once and have a fixed repayment schedule,” says Bill Gandolfo, Senior Product Manager – Consumer Lending at Commerce Bank. “People can budget for that which makes it easier to pay over time.”

Personal Line of Credit:

On the other hand, a personal line of credit is a revolving line of credit, which is similar to a credit card. You can use the funds up to a certain limit when you need to, but you must pay back the amount you borrow with monthly payments that can fluctuate based on your balance owed. Interest rates depend on the change in the prime rate set by your lending institution, so it’s important to understand how interest rates and variable interest can impact a personal line of credit.

A personal line of credit is often used for those “what if” moments, where you know you may need to access the funds but aren’t sure how much you will ultimately need. They can also be used as a security net should an unexpected situation arise.

“Be careful not to carry too high of a balance compared to your limit” says Gandolfo. “It could potentially hurt your credit score from a utilization perspective. Generally, a 30% utilization or lower looks good as long as you’re making payments on the amount you borrow. It’s not necessarily bad if you go over and you’re paying your bills, but your credit score may not be as high.”

Understanding how you will use the funds

In some cases, a personal loan can help you save on interest payments and lower your debt because it’s a form of credit given to you up front. On the other hand, your payments on a personal line of credit can vary based on your current balance, but it’s a way to have access to funds when you’re unsure how much you’ll need. They can help or harm your credit score based on your utilization. Both can be used to pay off purchases like home renovations, unexpected expenses, medical bills or even as a way to consolidate debt.

When it comes to home improvements, Gandolfo has some tips. “You don't want to necessarily use a personal loan for that, because you have to borrow a fixed amount up front and pay interest on all that money that you haven't yet used,“ he said. “But if you take out a line of credit, you only pay for what you end up needing over time.”

He goes on to elaborate: “The difference really comes into play when determining how you need the money. If it’s more of a cash flow over time for unexpected expenses, or if it can be a resource of a lending need — that's the line of credit. If you need it all at once — that's the loan.”

The bottom line

It’s important to understand the different ways taking out a loan or line of credit could impact you, and which is appropriate for your situation. Consider how you will be using the money and your financial habits when it comes to paying off debt. Setting yourself up for success means understanding the terms of either option and what’s best suited for your needs.


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