Loans vs Lines of Credit: Which is Best for You?
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When you need or want to buy something that exceeds your available funds, it is common to borrow the money elsewhere. If you can’t get it from friends and family, the following practical solution is to apply for the funds from a bank or lender. However, most consumers are unaware that there are multiple borrowing options, including a loan or line of credit. Ultimately, the differences between these financial products will help you determine which one is best suited to your circumstances.
What is a loan?
A loan is a specified dollar amount made available to another person or entity by a person, company, or financial institution in exchange for the borrower’s promise to pay the interest and the loan balance in full by the agreed date. It is a set amount of money intended for one-time use. There are many different types of loans, including mortgages, personal loans, car loans, home equity loans, student loans, payday loans, and installment loans. A little internet research can help you discover this What is the difference between a payday loan and an installment loan or the difference between a mortgage and a home equity loan.
What is a line of credit?
A line of credit is a form of loan as it is financing from one person or company to another. However, lines of credit are a fixed amount of money that can be used as many times as the borrower needs (or until the account is exhausted).
What is the difference?
While the definitions of loans and lines of credit give you some insight into their differences, let’s dig a little deeper into how these financial products differ.
- Frequency of use – The most significant difference between a loan is the frequency of use. A loan is non-revolving, meaning you can only use the amount borrowed once. You then have to pay off the loan in full and, if necessary, apply for another one. A line of credit is revolving, which means you can use the amount you borrowed, pay back the balance, and use it as many times as you see fit.
- Borrower Needs – Although personal loans can be used for any purpose, other loans are designed for a specific need. For example, a mortgage is used to buy a house, an auto loan buys cars, and student loans fund college tuition. On the other hand, you can use a line of credit to fund anything.
- Accrued Interest – Once you get a loan, interest starts accumulating. However, a line of credit does not accrue interest until you begin spending from the account.
- repayment – If you accept a loan, you must immediately start paying off the balance plus interest until you have fulfilled your obligation. With a line of credit, payments are not required until you spend money. Plus, you only pay for what you use with a line of credit instead of owing the entire balance.
Which one should you choose?
How do you know if you need a loan or a line of credit? Below are two factors to consider:
- Financial Needs – The first thing to consider is why you need the money. If you’re trying to buy a home, car, or pay for college, a loan may be a better option because you can apply for specific loans that can give you larger amounts of money to make those important life investments. However, if you live paycheck to paycheck and want a financial cushion, often needing extra money to make purchases or meet ongoing expenses (e.g. dental work, college tuition (beyond tuition), etc.), a line of credit would make sense Ideal.
- affordability – Being in debt can be a good thing, but too much debt can cause problems. Therefore, you want to choose the cheapest loan option. For example, a bank might offer lines of credit at 12% APR or 1% monthly interest. However, a personal loan can range from 10% to 36%. You don’t have to worry about repaying a line of credit when the balance is at zero; However, once you take out the loan, you will have to pay the required interest rate and the balance in full. If you’re trying to save money and not get into too much debt, a line of credit may be a better option.
When you find yourself in a jam or just want to make a major life purchase, applying for a loan or line of credit is often the quickest way to achieve your goals. Hopefully the information provided above has given you a better understanding of the differences, benefits and common uses so you can decide which one is best for you.