If you are looking to borrow funds, two popular options are loans and lines of credit. They do have similarities – both are ways to borrow money and repay it over time. But there are also key differences between a loan and a line of credit.
With a loan, you get given money once and repay it in fixed instalments. A line of credit is what’s called ‘revolving credit’. You are given a credit limit which you can draw/borrow from. Whatever you repay can be borrowed again, within your credit limit. Which one will suit you will depend on your personal circumstances.
In this article, we will go through the differences in lines of credit and loans in more detail. So, if you’re trying to decide which will work better for you, read on.
Table of Contents
What is a loan?
A loan is a form of credit. It is when a lender gives money to a borrower, and the borrower agrees to pay it back. Most loans also include interest, which is an extra cost added to the amount borrowed. Loans are usually paid back in regular, fixed monthly payments.
Lenders can include banks, credit unions, and other financial firms.
Types of loan
There’s not necessarily a best type of loan, as it’ll depend on what you want or need. Here are some popular types of loans.
Personal loan
A personal loan is a sum of money borrowed from a lender, which you repay in fixed monthly instalments over a set period, usually with interest. People often use them to pay for cars, unexpected expenses and beyond. Loans borrowed from friends or family can also be classed as personal loans. However, most people mean loans from banks or other lenders when they use this term.
Business loan
A business loan is made to a business rather than a person. These loans are often larger and based on the business’s income and expenses. Applying for a business loan may involve more checks and paperwork. The funds must be used for business purposes.
Secured loan
A secured loan is backed by something valuable that the borrower owns. This item is called collateral. If the borrower does not repay the loan, the lender can take the item. Examples include car loans or mortgages.
Unsecured loan
An unsecured loan does not require any collateral. Instead, lenders will look at things like your credit score and payment history. These loans can include payday loans, short term loans, debt consolidation loans, and others. The terms may depend on your creditworthiness.
What is a line of credit?
A line of credit lets you borrow up to an agreed limit. You can use any amount up to that limit when you need it. The amount you haven’t used stays available to borrow. Lenders may set fixed monthly repayments, but you can usually repay early to reduce interest. Once you repay what you’ve borrowed, the credit becomes available again.
Lines of credit can be a flexible way to borrow. They are often offered to people with strong credit scores. However, they may still be available to those with lower credit scores, though terms may vary.
Types of credit lines
There are different types of credit lines depending on how they’re used. Here are some of the most common ones:
Overdraft
An overdraft is linked to your bank account. It allows you to spend more money than you have, up to a set limit. Some overdrafts may be interest-free, depending on the terms.
Credit card
A credit card is a separate account that allows you to borrow money to make purchases or withdraw cash. You can spend up to your credit limit and repay over time.
Personal line of credit
This is an unsecured type of credit line. It isn’t tied to your bank account or credit card. You borrow money, and it’s transferred to your account. These often have higher interest rates due to the increased risk for the lender.
Business credit line
This is for business use. The business can borrow when needed for expenses. These can be secured (backed by an asset) or unsecured.
Key differences between a loan and a line of credit
1. Type of credit
A personal loan is a one-time credit agreement. The lender provides a lump sum upfront, which is paid back over time in fixed instalments.
A line of credit is a revolving credit arrangement. The lender approves a fixed limit, and you can borrow up to that limit again and again. For instance, if your lending limit is £1,000 and you make a purchase of £600, your available balance will be £400.
2. Credit limits
A personal loan will usually allow you to borrow more money than a line of credit. As lines of credit are ongoing, lenders tend to approve smaller amounts as credit limits.
For example, if you need a significant amount of money to buy a car, you’ll be more likely to get a loan. As a credit line has a smaller limit, it’s more likely to be used for smaller, day-to-day expenses.
3. Repayment schedule
Loans have arranged repayment schedules that you’ll be expected to follow throughout the repayment period. The amount of each repayment will also be fixed. With some loans, if you pay earlier than this, you may incur early repayment charges.
With a line of credit, you can make flexible repayments. You’ll have minimum monthly payments, but you can repay more than this at any point. However, keep in mind that the longer you wait to pay, the interest keeps piling up.
4. Interest rate
If we compare bank loans vs lines of credit, lines of credit typically have higher interest payment rates. Lenders consider loans to be less risky than credit lines because they have fixed repayments. However, your actual interest rate will probably depend on your credit history and credit score. You might find on a line of credit you’ll have a variable interest rate.
5. Interest accrual
In the case of a personal loan, interest begins to accrue immediately on the entire loan amount. This is because the entire amount is paid upfront to the borrower, so repayments take interest into account. However, for a line of credit, you pay only on the amount you use, not the entire credit limit. For example, if you make a purchase of £300 in a month, you will have to pay interest only on £300. You won’t have to pay interest on your available balance.
Here’s a summary of the line of credit and loan differences discussed above.
When to choose a loan?
Taking a loan is usually a better option than a line of credit when:
- You need to borrow a large sum of money right away.
- You want funds for a specific purpose such as buying a car, a house, or paying for university.
- You prefer to pay the credit back in fixed instalments.
- You need one-time access to money and don’t need ongoing credit.
- You are looking for a credit option with generally lower interest rates.
When to choose a line of credit?
Credit lines could be a wise choice if:
- You are looking for ongoing credit to manage your regular expenses like groceries, household costs, etc.
- You are looking for a flexible credit option which you can use whenever needed.
- You’re comfortable that you won’t let debt pile up. This is a crucial point because some people fail to pay their line of credit on time. The longer you borrow without repaying, the more it’ll cost.
Conclusion
The bottom line is that both loans and credit lines can be excellent credit options when used in the right circumstances. And now, hopefully, you’ll understand more about the difference between a loan and line of credit.
Consider the immediate and potential cost. Will you be charged a late payment fee? What happens when the repayment period begins? What’s the available credit? What are the interest charges?
FAQs
Is a personal line of credit considered a loan?
A line of credit is distinct from a loan. With a loan, you get the entire amount at the start and repay it gradually. With a credit line, you borrow/draw and repay as you need it. It will also be reported differently on your credit report.
What is an example of a line of credit?
A credit card is a popular example of a line of credit. Other examples include overdrafts, business lines of credit, and personal lines of credit.
Can you get a personal line of credit in the UK?
You can get a personal line of credit in the UK subject to your credit score, your income, your credit history, etc.
Disclaimer: The information given above is provided for reference only. This is not financial advice.
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