A personal loan and line of credit might sound similar, but there are a few differences, and how you intend to use the money usually makes the difference in which is right for you.
While a line of credit or personal loan can help cover a number of expenses from home repairs or car repairs or medical bills or other expenses, it’s important to weigh the options for your own situation.
With Canadian household debt on the rise, one of these options might be what you are looking for to help better manage your finances.
What is a Personal Loan?
A personal loan is an unsecured loan that relies on a fair to good credit score to qualify and a popular way to borrow when funds are needed.
This is a form of credit available as a lump sum you would receive all at once. Often used for things like a large purchase, debt consolidation or unexpected expenses, they are structured where you would have a repayment schedule based on the terms agreed to and the interest rate, which would depend on your creditworthiness, or credit score and other factors. A personal loan might be used most often to pay off outstanding debt for lower monthly payments or paying less interest.
What is a Personal Line of Credit?
With this option, you would have what is referred to as revolving credit, which is similar to a credit card in the sense that you have been pre-approved to use up to a certain limit and only charged interest on the credit used. If you had a line of credit for $5,000 but only used $1,000, then you would only be charged interest on the $1,000 used.
What are the Main Differences?
The main difference between a personal loan and a line of credit is that a personal loan is provided as an entire amount when approved and payments start immediately, where a line of credit is an amount available to you and payments start after you make use of the funds.
A personal line of credit can have lower costs than a personal loan, and both are unsecured. If you were using a home equity line of credit it would be secured and likely with better interest rates available. Overall, the main differences are the rates, how funds are available, and how repayment works.
What Kind of Fees are Involved?
With personal loans the cost of borrowing can depend on the lender. In addition to the interest rate, there can also be other costs like origination fees or a penalty for paying off early. It’s best to become familiar with the terms by carefully reading the loan agreement before signing.
With a line of credit they usually have variable rates, which means your monthly payments can fluctuate, unlike personal loans which have fixed monthly payments. A line of credit can also come with other costs, like an annual fee, which you would have to pay whether you make use of the funds available in your line of credit or not. Some find the liquidity of the payments appealing, but it’s important to make more than the minimum payment in order to take care of your balance and avoid interest.
How to Qualify for a Personal Loan
Lender eligibility varies from one to another, but many share certain requirements in order to prequalify for a personal loan. Having a good credit of usually 700 or more is a place to start. You’ll also need to provide a verifiable income and some other personal details. Additionally, your debt-to-income ratio (DTI) might not be part of your credit score, but it is something that many lenders will also look at as well.
How to Qualify for a Line of Credit
Since a personal Line of Credit (LOC) is unsecured, unlike home equity lines of credit (HELOCs), this means some risk to the lender, and similar with personal loans. To qualify for a line of credit it is necessary to demonstrate creditworthiness in order to be approved. Being default free on loans in recent years is a good start, and sharing all sources of income, in combination with having a good credit score.
Which One is Best to Use?
You would really need to look at your financial situation along with how you intend to make use of the funds as there isn’t an answer that fits everyone.
A personal loan can make more sense for a one-time purchase, but for a project or situation where the costs are not clear at present or ongoing, a line of credit can make more sense. All things considered, a personal loan comes with fixed monthly costs, which can appeal to many.
A line of credit can be like having a tool in place according to some financial advisors. It’s similar to an emergency fund or safety cushion that’s there to withdraw from if you need it. With a line of credit, having the option standing by can provide peace of mind if you don’t have an emergency fund.
Regardless of whether you choose a personal loan or line of credit, it is likely that your credit score would take a small dip, but this is temporary and to be expected that it might drop a few points for a while. As with any financial decision, it is strongly advised to practice some form of responsible borrowing to avoid issues later, to keep the option of borrowing available to you.
While your credit history doesn’t have to be perfect, it definitely determines what interest rate you might get and the overall cost of the loan. But it is possible to get a loan with bad credit and so long as you realize the interest rates will be higher it’s an option available to you.
For those with poor credit scores where a personal loan or line of credit might not be an option, there are other borrowing options like installment loans to consider should you not qualify for a personal loan.