Personal Line Of Credit Vs. Personal Loan: Choosing The Right Option

It’s quite possible that at some point in your lifetime, you’ll need to seek financial assistance with larger expenses. Maybe you want to consolidate debt, or perhaps you want to complete some home repairs. Whatever the reason, a number of financing options can help you achieve your goals.

Two of the most common lending options are personal loans and personal lines of credit. Let’s explore how they’re different and when each option could be the right choice for your situation.

A personal line of credit (PLOC) is a type of financing that allows you to borrow a specified dollar amount from a lender over a certain amount of time – often called the draw period. You can use the funds to cover expenses without having to withdraw the entire loan amount.

You can make payments throughout the draw period on the money you’ve used, freeing up more funds. This is similar to how a credit card works. During the draw period, you may be required to make minimum monthly payments or interest-only payments; it all depends on the lender.

Once the draw period ends, you’ll be required to pay what you’ve borrowed and haven’t already paid back, plus interest. This period of time is called the repayment period, and it may last for many years.

As previously mentioned, a personal line of credit allows borrowers to access funds as needed within the predetermined draw period and make payments throughout the draw period, after the draw period ends, or both. On the other hand, a personal loan is a larger sum of money borrowed from a lender that the borrower pays back over the course of a loan term that typically lasts at least a few years.

Both of these financing options can be secured or unsecured. With a secured personal loan or line of credit, the borrower puts up an asset like a home or their car to act as collateral if they fail to make payments to their lender. With an unsecured personal loan or line of credit, no collateral is necessary.

While the purposes of these two financing options can be similar, you can make a few noteworthy distinctions between them to determine which option would best serve your needs.

Distribution Of Funds

One of the biggest differences between personal loans and personal lines of credit involves the way the borrower gains access to the money they’ve been approved to borrow. With personal loans, the borrower can typically access all of the money they’re borrowing in an upfront lump sum at the beginning of their loan term.

With personal lines of credit, the borrower is typically approved to use the line – which can often be accessed through a card connected to the account or through checks – up to a certain financial limit, at which point they can pay off their balance and repeat the cycle whenever they need to access funds within the scope of their credit line.

Repayment Process

Another major difference between a personal loan and a personal line of credit is in how the borrower pays back the money they owe. As mentioned above, borrowers who use personal lines of credit can make payments as needed, whether it’s paying minimum balances each month, paying down the full balance once the credit limit is reached or paying off the loan during the repayment period.

Personal loans, on the other hand, tend to be paid off by the borrower in fixed monthly installments for a predetermined length of time. However, if the cost of payments on a personal loan gets to be too much for the borrower at any point, their lender may offer the option to restructure or refinance their loan to lower the monthly expense.

Interest Rates

Both personal loans and personal lines of credit charge interest, but the interest rates for personal lines of credit are typically higher and variable, meaning they fluctuate. With personal loans, fixed interest rates are more common, meaning they won’t change over the course of the loan term. And, in most cases, personal loans will have lower interest rates than a PLOC.

Personal loans and lines of credit also accrue interest differently. With a personal loan, your interest will start as soon as the term begins, but you don’t pay interest on a personal line of credit until you use the funds.

Personal loans can help borrowers who need a substantial amount of financing for a project or big purchase. They give you the ability to access the funds you need without putting a heavy dent in your savings or paying back everything you owe right away.

The consistent nature of personal loan repayment also makes it easier for borrowers to develop a budget around. This means a personal loan can oftentimes be more financially sustainable than a personal line of credit.

A personal loan works best when you know exactly how much money you’ll need to borrow. You can use a personal loan for:

• Debt consolidation
• Large purchases (such as a car, motorcycle or boat)
• Emergency charges
• Small to medium-sized home improvement projects

Risks To Consider

Because a personal loan is for a set amount of borrowed money, there’s always the risk that this amount might not end up being enough to cover all of the expenses incurred in the project you’re taking on or the investment you’re making.

If, for example, you’re halfway through a major home renovation and you’ve discovered that a leak in your roof caused the underlayment to start rotting, you’ll probably have to spend more than you were planning to fix the issue. This can be especially problematic if you’ve already budgeted for the project and been approved for a specific amount. In this case, a personal loan might not be the best financing option you could have chosen. Instead, a home equity line of credit might have worked better.

However, this doesn’t mean you shouldn’t use a personal loan for any type of home improvement project. Personal loans are an excellent way to finance smaller-scale projects, like upgrading kitchen appliances, replacing bathroom tiles or building a deck, as these types of improvements are less likely to uncover hidden problems. But if you want to make significant changes, such as adding an addition or finishing a basement, you might want to consider either overestimating how much you’ll need to borrow or going with a line of credit.

You should also keep in mind that some personal loans require an application fee. You could have a prepayment penalty, too, if you pay off your loan before the term ends.

Furthermore, committing to a personal loan can mean being in debt for a longer period than if you take on a personal line of credit.

Personal lines of credit act as a great option if you aren’t sure exactly how much money you’ll need. A personal line of credit can give borrowers more flexibility with accessing money as they need it over a longer period of time and paying back what they owe in increments of their choosing.

You can use a personal line of credit for:

• Ongoing medical expenses
• Large home improvement projects
• Business investments

Risks To Consider

Because of the inconsistencies that can occur with how much money gets borrowed within the credit limit and how often the borrower uses their account, personal lines of credit can sometimes make budgeting difficult.

There’s also the temptation to charge expenses and pay them off whenever you feel like it, which means you can quickly accrue interest without notice. With a personal line of credit, it’s likely you’ll have a higher interest rate, making it easier to rack up a substantial amount of debt.

Lenders may charge you an application fee and an annual fee to use a personal line of credit. If you miss a payment on your account or make too big of a purchase, you’ll be charged late or overdraft fees, which can increase the cost of using this type of financing and make it more expensive than a personal loan.

The requirements for a personal loan are generally less strict than those for a personal line of credit. Since a PLOC is more flexible with its repayment schedule and loan terms, most lenders will only approve borrowers with great credit scores and low debt-to-income ratios.

While every lender has specific requirements for borrowers, lenders seem to universally prioritize the following traits in borrowers seeking a personal loan or a personal line of credit:

• A good or excellent credit score
• A stable source of income
• A good debt-to-income ratio

Since lenders assess a borrower’s creditworthiness by reviewing their credit score, you should take steps to build your credit so you have a better chance of approval. Before applying for a personal line of credit or a personal loan, it’s also wise to check your credit report for any errors.  

When it comes time to choose an option for financial assistance, you’ll ultimately have to assess whether the features of a personal loan or a personal line of credit will help you the most in completing your desired projects or pursuing your short- and long-term goals. It’s best to consider which of the two options is the most sustainable for your personal finances with regard to making payments and fitting the added expense into your budget.

If you’ve decided that a personal loan sounds like the right choice for you, Rocket Loans℠ is here to help! Get started on your journey toward financing approval today.