September 27, 2022

Here’s How You Can Choose Between a Personal Loan and Personal Line of Credit

Sometimes you just could use a bit more cash. Maybe you need help covering moving expenses, or you’re buying a new set of wheels. Or maybe you just want to consolidate your debt into one easy-to-manage place.

If you need funds, a personal loan or personal line of credit can be a good option. While they have similarities, they are distinct products with advantages and disadvantages. It’s important to understand how these products work before applying.

Personal Loan vs. Personal Line of Credit

A personal loan provides a lump sum you can use immediately and then repay in fixed installments over a set period of time. A personal line of credit is a form of revolving credit that works much like a credit card. You’re typically able to access funds up to a limit during the loan’s draw period, and you must pay back any amount you borrow with at least minimum monthly payments.

Both types of debt are generally unsecured, meaning they are not backed by collateral such as a home or car. There are other key similarities and differences between personal lines of credit and personal loans in how you can access and ultimately repay each.

How to Apply for a Personal Loan or Personal Line of Credit

The application processes for personal loans and personal lines of credit are similar.

“You will go through a relatively standard application process online or via paper application, and, depending on the provider, you will most likely need to provide income verification with a W-2 and/or pay stubs,” says Ted Braun, vice president and financial advisor at Wealth Enhancement Group.

You can often prequalify for a personal loan or line of credit with only a soft credit pull, but a hard credit check will be necessary once you proceed with your application.

Hard credit checks can lower your credit score by up to five points, but keep in mind that credit inquiries for the same type of loan will be counted as one if you do your rate shopping within a short time frame.

How to Qualify for a Personal Loan or a Personal Line of Credit

There are some common factors you should expect lenders to consider whether you are applying for a personal loan or line of credit.

“Credit score, income and how much you’re looking to borrow will all determine how likely you are to receive a loan or line of credit,” says Brandon Ashton, director of retirement security at Cornerstone Financial Services. “A lender also might want to know your debt-to-income ratio, recurring monthly debt, whether you rent or own your primary residence and how long you’ve been with your employer.”

You’ll generally need at least good credit to qualify for a personal line of credit. This means a credit score of 670 or higher.

Meanwhile, you may be able to get a personal loan with fair or poor credit, but at the cost of less favorable rates. If you have poor credit or no credit history, you may need to get a co-signer for a personal loan, Ashton says.

Using and Repaying Personal Loans and Personal Lines of Credit

Where personal loans and personal lines of credit really begin to differ is in how you receive the funds and repay them. As mentioned, personal loans provide a lump sum, while you can choose how much to borrow from a personal line of credit, up to a limit.

Repaying a personal line of credit is much like repaying the balance on your credit card. “You borrow money as needed and make at least the minimum monthly payments every month,” says Daniel Rodriguez, chief operating officer at Hill Wealth Strategies. This means that you won’t owe anything on your line of credit until you start using it.

With a personal loan, on the other hand, you will receive the full loan amount upfront and then repay it in fixed installments over a predetermined period of time. “This allows for a regular cadence of payments and a more structured way to pay the loan back,” says TJ Duffy, head of personal lending at TD Bank.

Typically, personal loans will have fixed interest rates, while personal lines of credit will have variable rates. This means that monthly payments on a line of credit will vary based on factors such as how long you want to take to repay the amount borrowed and changes in interest rates during that time, Duffy says.

“Personal lines of credit usually have higher interest rates because the lender is assuming greater risk,” says Rodriguez.

Make sure you understand terms such as the length of the draw period, which is how much time you’ll have to access funds, before agreeing to a personal line of credit, Braun says. “At the close of the draw period, the line will be amortized into a fixed-rate loan with a clearly defined payback period.”

Repayment requirements and the length of the payback period may vary, so check the terms of your line of credit. You also want to confirm any interest rate caps or lack thereof, Braun says.

How to Choose Between a Personal Loan and a Personal Line of Credit

You can use a personal loan or a personal line of credit for a variety of reasons. Either can be used to consolidate debt, pay for a wedding, fund home improvement projects or vacations, or even to cover short-term emergencies, Ashton says. That said, each has uses it is better suited for.

“A personal loan is typically used when you have a specific need and know the amount of the loan in advance,” Duffy says. “The advantage would be a fixed payment with a fixed rate over a fixed period of time,” which makes budgeting far easier.

You can also use personal loans to consolidate higher-interest debt into one fixed monthly payment.

“Say, for example, you have built up a few credit card balances, and potentially have a car loan nearing the end with a high payment,” Braun says. “You could use the personal loan to pay these off and end up with one lower monthly payment.”

Braun cautions against getting into what he calls a “reloading cycle” where you consolidate debt into a personal loan, then make more purchases on your credit cards. “This can be a vicious cycle to break once you get into it,” he says.

Personal loans can be particularly advantageous as interest rates rise by letting you lock in a fixed rate, Duffy says.

Meanwhile, a personal line of credit may be best if you aren’t sure how much you’ll ultimately need to borrow.

“A line of credit provides consumers the flexibility to access cash for unexpected events or when funds will be needed over an extended period of time, such as with an extended home renovation project,” Duffy says.

Braun says personal lines of credit are more useful in “what-if” scenarios, when you know you’ll need more cash than you have but don’t know how much more. “A personal line allows for flexibility when you are uncertain on how much you might need,” he says.

Setting yourself up for success with either product means understanding the terms and making sure you’ll be able to repay the debt on time.

Source link