Line of Credit vs Loan: Differences Explained

A loan is a fixed amount of money borrowed from a lender, typically a bank, credit union, or fintech company. You can get loans for different amounts, ranging from a few hundred to six figures or more, depending on the type of loan, your income, and your credit score.

Loans come in various types and serve specific purposes. For example, a mortgage is a type of loan to buy a house, while an auto loan is used to buy a car. You can also take out general personal loans that give you cash to spend however you want.

When you take out a personal loan or other type of loan, you agree to repay the borrowed amount (principal) plus interest over a set period. You need to qualify for a loan based on your credit score, income, and assets.

Example of a loan

Let’s say you need $10,000 for an emergency home repair. You go to the bank and apply for a one-year personal loan, and the bank approves your loan with a 13% interest rate.

You receive the $10,000 upfront and then agree to pay about $900 a month for a year to cover the debt plus interest. After you pay off the loan in 12 months, it’s over. You’ll need to submit a new application to borrow money again.

Pros and cons of loans

Pros:

• Fixed payments: Loans typically use fixed interest rates with predictable monthly payments that don’t change. This makes budgeting easier.¹
• Lump sum: You receive the entire loan amount upfront, which is beneficial for large one-time purchases.
• Lower interest rates: Loans generally have lower interest rates, especially for borrowers with good credit.²

Cons:

• Less flexibility: Once you receive a loan, you cannot borrow more without applying for a new loan. Each loan is a one-time chance to raise money.
• Interest accrual: Interest starts accruing on the full loan amount immediately. It can quickly add up, especially on larger loans.
• Prepayment penalties: If you try to pay off your loan early to save on interest, the lender may charge you a penalty for doing so.¹

A line of credit (LOC) is a flexible loan from a financial institution that allows you to borrow up to a certain limit. You can draw funds as needed and pay interest only on the amount borrowed. Once you pay off the borrowed amount, you can borrow again against the same line of credit.

An unsecured line of credit is backed up only by your credit score. A secured line of credit is backed up by a valuable asset that the lender could take if you miss payments. A home equity line of credit (HELOC) is a common secured type where the line of credit is backed up by your house.²

Example of a line of credit

Let’s say you go to the bank and apply for a line of credit. The bank decides to give you a $10,000 line of credit based on your income and credit score. You don’t receive that cash right away, but it’s there to borrow when you need it.

Two months later, you borrow $2,000 to pay off a medical bill, leaving you with $8,000 left on the line of credit. One month later, you borrow another $1,000 for a vacation. By the end of the year, you get a bonus which you use to pay off the $3,000 debt plus any interest. You can then borrow up to the full $10,000 again.

Pros and cons of lines of credit

Pros:

• Flexibility: Borrow as needed up to your credit limit.
• Pay interest only on borrowed amount: You only pay interest on the funds you use. That can reduce your total borrowing costs
• Revolving credit: As you repay, you can borrow again without reapplying.

Cons:

• Higher interest rates: LOCs typically have higher interest rates, especially if unsecured.
• Variable rates: Interest rates can fluctuate, leading to unpredictable payments.
• Fees: Lines of credit can charge fees, such as an annual maintenance fee. You owe these fees even if you aren’t borrowing against the line of credit.²

Understanding the key differences between a line of credit vs loan can help you choose the right financial tool.

• Access to money: A loan is a one-time chance to borrow money. A line of credit is a chance to borrow repeatedly without another application.
• Qualifying: It’s usually harder to qualify for a line of credit than a loan. You need a higher credit score and are more likely to need collateral to secure the debt.
• Borrowing limits: The maximum borrowing limits for loans are usually higher than for a line of credit. A line of credit might be for five or low-six figures at most, whereas a loan can go higher, depending on your creditworthiness.²
• Fixed vs. variable rates: Loans typically use a fixed interest rate, meaning your monthly debt payments stay the same the entire time. Lines of credit typically use variable interest rates, which can fluctuate depending on market conditions. Budgeting can be trickier on a line of credit as it’s less certain what you’ll owe over time.
• Interest charges: Loans start charging interest on your debt immediately as you receive all the money upfront. Lines of credit don’t charge interest until you borrow money. You could set up the line of credit with the plan not to use it until later.

Loans come in various forms, each suited to different needs.

• Unsecured loan: No collateral is needed for personal loan requirements. Qualifying is only based on your income and credit score.
• Mortgage: Used to buy a home, secured by the property.
• Car loan: Financing for purchasing a vehicle.
• Home improvement loan: Provides funds for home renovations and improvements.
• Business loan: Capital for starting or expanding a business.
• Debt consolidation loan: Combines multiple debts into one loan with a lower interest rate. For example, you could use a debt consolidation loan to pay off all your credit cards and then only have one monthly loan payment.
• Student loan: Student loans fund education expenses, often with more favorable terms compared to regular personal loans.

There are also many types of lines of credit for different situations.

• Personal line of credit: A personal life of credit is unsecured. You don’t have to put up any assets to secure the loan. In exchange, the interest rate is usually higher than secured lines of credit.
• HELOC: A HELOC is secured by home equity for a house you own, usually your primary residence.
• Business line of credit: Provides flexible funds for business expenses.
• Securities-backed line of credit (SBLOC): A line of credit backed up by securities in your investment portfolio, like stocks or mutual funds.
• Demand line of credit: Requires full repayment upon demand by the lender. There’s a chance you’d need to pay everything off sooner than expected.³

Choosing between a line of credit and a loan depends on your financial needs, repayment ability, and goal for the funds.

• Line of credit: Ideal for ongoing expenses or emergencies due to its flexibility and revolving nature. Best if you need funds sporadically and prefer to pay interest only on what you use.
• Loan: Best for large, one-time expenses with predictable repayment schedules, like a house or car. Ideal if you want lower interest rates and fixed monthly payments.

So what should you not use a loan to purchase? Loans don’t usually make sense for smaller, repeatable expenses, like utility bills or groceries. It takes too long to qualify. A line of credit, a credit card, or your savings are better for these costs.

Remember, it’s not an either/or decision. You could apply for a loan and a line of credit at the same time for two separate financial goals. For instance, you could take out a loan to buy a car and then set up a line of credit as a backup for future emergency expenses.

If you’re still unsure whether to use a line of credit vs loan, ask to speak with a representative from your bank or online lender to discuss your options. You could also meet with a financial planner first. That way, you can figure out the right borrowing solution for your goals and credit.

Not sure if you have good enough credit for a loan? Find out how to use a loan to build your credit score.