The difference between a personal loan and a line of credit is that a loan is a lump sum of money that must be repaid on a set schedule, whereas a line of credit can be used and repaid on an ongoing basis.
Comparing personal loans and lines of credit
Personal loans and lines of credit can both be powerful financial tools to access funds to cover big expenses like buying a new car or financing a home renovation. But knowing how they work can help you decide which one is a better choice for your needs.
Personal loan definition
A personal loan, sometimes called an installment loan, is a fixed amount of cash you can borrow from a financial institution or private lender and agree to repay with interest over a set period of time.
Line of credit definition
A line of credit, also called a personal line of credit, is a form of revolving credit generally available from banks and credit unions. It gives you ongoing access to a set amount of money to use as needed. You’re only charged interest on the amount you withdraw from the account.
As long as you pay the required minimum monthly payments, your line of credit is still open, and in good standing so you can continue to have access to the money.
Line of credit and personal loan: Common features
Although personal loans and lines of credit work differently, they do have a number of features in common.
Criteria to qualify
Most financial institutions have a minimum set of criteria that you must pass to qualify to apply for a loan or line of credit, including:
- Resident of Canada. You may need to prove that you’re a resident of Canada.
- Age of majority. You will likely need to be the age of majority in your territory or province.
- Income or employment. Lenders may require that you show proof of income such as a pay stub to apply. Particularly for lines of credit, lenders might want to see a minimum household income of $35,000 to $50,000. Personal loan lenders, especially alternate lenders, can be more flexible about income requirements, though you’ll likely still have to verify your income.
With some exceptions, lenders of both personal loans and lines of credit will want to do a credit check for insight into your credit history and score, so they have an idea of your creditworthiness.
Scores of 660 and above are generally perceived as good, but the higher your score, the better chance you have of being approved and getting the best rates. Improving your credit score can vastly improve your odds of getting approved for any type of loan or line of credit.
Mostly issued by financial institutions
Most traditional financial institutions, including banks and credit unions, offer both lines of credit and personal loans in Canada. Some alternative and private lenders like payday lenders, who’re not associated with major banks, offer personal loans. However, their interest rates and fees may be higher than traditional banks and credit unions.
Require you to pay interest
Lenders offer loans because they earn a profit on the interest they charge you for that privilege. Whether you take out a personal loan or a line of credit, you’ll pay interest on the money you borrow.
Personal loan vs. line of credit
While personal loans and lines of credit are both borrowing methods, these differ in terms of how and when you access the funds and accrue interest, typical uses, and more.
Personal loans and lines of credit are subject to interest which varies in both cases. The interest on a line of credit accrues on the funds you withdraw, not on the full available amount in your account. You can pay back what you owe at any time to stop interest accruing, or make a minimum payment each month, which usually covers your interest owed.
With a personal loan, you’ll pay interest on the entire lump-sum amount. You’ll make set payments on a predetermined schedule over the course of your loan term. These payments will go toward both interest and your loan principal.
Personal loan interest rates can be either variable — subject to change or fixed — stay the same over the loan’s term. Although, lines of credit tend to have variable rates based on the lender’s prime rate.
A personal loan is typically used for a specific purpose, whereas a line of credit is often a way to have access to funds even if you don’t know how you want to spend them yet. A line of credit can be a good backup for emergencies or unexpected expenses if you’re still working on building up your emergency fund.
There are no rules about what you can purchase with a line of credit versus a personal loan. That being said, lines of credit can be ideal for ongoing, smaller needs because you only pay interest on the funds you use. Personal loans may be a better fit for major one-time expenses, like buying a car or doing a major home renovation.
Revolving vs. non-revolving credit
A line of credit is revolving credit because you have open-ended access to the funds — keep withdrawing and repaying borrowed money as and when you need, provided your account is in good standing.
A personal loan is non-revolving credit because once you pay it back, you lose access to that credit. If you want to access it again, you’ll have to apply for another loan.
Types of personal loans
Debt consolidation loan. A debt consolidation loan comes with a reasonable interest rate that you can use specifically to pay off higher-interest debts, such as credit card balances. The idea is that it’s easier to repay a single loan and save money through a lower rate of interest.
Unsecured loan. In contrast to a secured loan, an unsecured loan doesn’t require collateral against non-payment, like a house or car.
An unsecured personal loan is sometimes called a signature loan because your signature secures the loan, rather than any of your assets.
Types of lines of credit
Personal line of credit. A personal line of credit is simply an unsecured line of credit, which means you don’t need to provide collateral. As with personal loans, unsecured lines of credit typically have a higher rate of interest than secured ones.
Home Equity Line of Credit (HELOC). This type of line of credit uses your home as collateral against nonpayment of any balance owing. HELOCs tend to have lower rates than personal lines of credit.
Business line of credit. Business owners can apply for a line of credit that gives them ongoing access to funds to help run and expand their enterprise.
Demand line of credit. Businesses can also use this type of credit, secured by their assets, like inventory or accounts receivable. Note, the financial institution can demand full repayment of the funds at any time.
Securities-Backed Line of Credit (SBLOC). With this type of secured line of credit, you use the value of your investments held in a brokerage account as collateral against non-payment.
Frequently asked questions
The main drawback of a line of credit is that it can make it tempting to overspend and gather debt because you have access to funds and you’re only required to make minimum payments to cover the interest.
Other drawbacks include variable interest rate options making payments unpredictable, eligibility requirements for a household income of $35,000 could be difficult to meet, and in the worst-case scenario, you could lose your home if you default on your HELOC payments.
With a personal loan, you receive a lump sum of money that you must pay back at predetermined intervals. Once paid, you’d have to apply for another loan if you want more funds. A line of credit is like an ongoing loan that you can withdraw and repay at any time, as long as you make minimum monthly payments. Additionally, loans may offer fixed or variable interest rate options, whereas lines of credit usually come with variable rates.
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