Do you foresee a large expense on the horizon for which you don’t have the money? Whether you need cash quickly and don’t have time to save up, or you’re reluctant to drain your current savings, you may be in a situation where the best move is to borrow.
Two popular financing options are personal loans and personal lines of credit. Which is best for your situation—and how do they differ? Read on, and we’ll break down what you need to know about personal loans and personal lines of credit.
What is a personal loan?
A personal loan delivers you an upfront lump sum of money to use for (nearly) anything you want. Upon account opening, you’ll be placed on a monthly installment plan with fixed payments and a clear end date. You will have fully repaid the amount you’ve borrowed and any interest when your loan terms. $100,000 is generally the most you can get from a personal loan—though a select few offer a higher borrowing amount.
Personal loans have fixed interest rates. When you open your account, the interest you pay will remain the same throughout the duration of your loan.
Pros and cons of personal loans
Pros
- Use the money for nearly anything
- Balance does not affect your credit utilization
- Predictable monthly installments
Cons
- Interest is unavoidable
- Little repayment flexibility
What is a personal line of credit?
Similar to a personal loan, a personal line of credit (sometimes abbreviated as PLOC) can also be used for just about any purchase. The big difference is the way you receive funds.
While a personal loan deposits the entire sum into your bank account, a personal line of credit simply unlocks the ability to borrow money when you need it. Think of it like a credit card; the bank stands ready to give you money, up to your credit limit, at your request, and you’ll only pay interest on the amount you use. When you repay money that you’ve borrowed, that portion of your credit line is restored.
A personal line of credit, typically, will have two phases:
- Draw period. The initial window during which you can borrow and repay your money (again, similar to a credit card)
- Repayment period. A window after the draw period during which you can no longer borrow money. You’re instead obliged to repay it either in equal monthly installments or all at once.
After the repayment period ends, your account will generally close, and you’ll have to reapply if you want a new line of credit.
Pros and cons of personal lines of credit
Pros
- Interest only charged based on balance you use
- Can be borrowed against and repaid repeatedly
- Payments may be lower to begin with, as you don’t have to borrow a large lump sum immediately
Cons
- High balance may impact your credit utilization
- Interest rates are often variable
- Less predictable repayment schedule
Personal loan vs. personal line of credit: Side-by-side comparison
| Personal loan | Personal line of credit | |
|---|---|---|
| Funds received | Upfront | As needed |
| APR | Fixed | Typically variable |
| Repayment flexibility | Equal installments | Based on current balance (during draw period) |
| Loan term | Typically up to 7 years | Typically up to 15 years (for example, with a 5-year draw period and a 10-year repayment period) |
| Credit score impact | Low | Potentially high (with a large balance) |
| Potential fees | Origination fee, early repayment fee (uncommon) | Annual fee, inactivity fee |
| Funds received | |
|---|---|
| Personal loan | Upfront |
| Personal line of credit | As needed |
| APR | |
| Personal loan | Fixed |
| Personal line of credit | Typically variable |
| Repayment flexibility | |
| Personal loan | Equal installments |
| Personal line of credit | Based on current balance (during draw period) |
| Loan term | |
| Personal loan | Typically up to 7 years |
| Personal line of credit | Typically up to 15 years (for example, with a 5-year draw period and a 10-year repayment period) |
| Credit score impact | |
| Personal loan | Low |
| Personal line of credit | Potentially high (with a large balance) |
| Potential fees | |
| Personal loan | Origination fee, early repayment fee (uncommon) |
| Personal line of credit | Annual fee, inactivity fee |
How to decide between a personal loan and a personal line of credit
Both products let you borrow money in similar amounts with potentially similar APRs, though of course your precise rates will depend on how each lender evaluates your financial profile.
The best option for you depends on your unique financial goals. Ask yourself the following questions to quickly decide whether a personal line of credit or a personal loan is a good idea for your situation:
Will you be making more than one large purchase?
If you’re opening a loan simply to fund a single big expense, a personal loan is likely the way to go. Its fixed APR and predictable monthly payments make it an easier-to-budget-for way to finance anything from a major auto repair to a wedding to an emergency medical bill.
A personal line of credit is better for those that plan to make multiple large purchases over a few years. A PLOC allows you to spend and repay your borrowed money over and over—so it may be perfect for, say, a home remodel that will take place in phases.
Are you consolidating debt?
For those who want to open a loan to consolidate other loans or high-interest debt, either a personal loan or a personal line of credit could serve your purpose. But keep this important detail in mind: A personal line of credit counts toward your credit utilization, while a traditional installment loan does not. This is important, because a low credit utilization (experts recommend no more than 30%) is a key aspect of a healthy credit score.
In short, relocating multiple credit card balances to a traditional personal loan will give you the benefit of a decreased credit utilization in addition to a potentially more reasonable APR and fewer monthly payments to keep track of.
How quickly can you repay your purchase?
On a related note, a personal line of credit may not be a good idea for funding a large purchase that you can’t soon pay off. Depending on the amount of available credit you’ve got and the size of your expense, your credit utilization can take a big hit and result in a decreased credit score. You can expect your credit to rebound as you pay down your balance.
Are you simply looking for an emergency fund?
Everyone should have an emergency fund to protect their finances against the unexpected. Ideally, this consists of money that you’ve already saved. Otherwise, you may feel compelled to look toward financing just in case.
A personal line of credit is a superior option in this scenario for two reasons:
- You’ll only be charged interest for money you actually use.
- You won’t have monthly payments unless you spend with your PLOC.
All to say, a PLOC shouldn’t dramatically affect your monthly budget (though you may be charged an annual fee or inactivity fee) if you don’t borrow against it.
An installment loan, on the other hand, will result in monthly payments with interest baked in. That means you’re paying a considerable amount of money for funds you may never use.
Alternatives to personal loans and personal lines of credit
Personal loans and personal lines of credit are just a couple of ways you can fund your purchases. Here are some other options that may better suit your needs:
- Credit card: If you’re looking for a tool to use for everyday expenses, credit cards are generally more convenient than personal loans and personal lines of credit. However, their lofty interest rates make them an unwise choice to finance a purchase you can’t pay off within a month or two. That said, some credit cards offer 0% intro APR periods for nearly two years.
- Borrow from your home equity: A home equity loan and home equity line of credit (HELOC) are ways to borrow from the equity you’ve built in your home. Home equity loans function similarly to a personal loan (funds delivered upfront with a monthly installment plan), while a HELOC functions similarly to a personal line of credit (revolving credit with a draw and repayment period). Depending on the amount of equity you’ve built into your home, you may be able to borrow more than you can get from a personal loan. Just note that a loan involving your equity uses your home as collateral.
- Borrow from friends and family: To avoid APR, debt-to-income limits, and credit score requirements, you may choose to ask for a loan from those close to you. But, ensure you agree on clear repayment terms to avoid damaging relationships.
The takeaway
To help you decide whether a personal loan or personal line of credit best serves your needs, consider things like repayment flexibility, loan term length, the unique impact that each loan type has on your credit score, and any potential fees.
Keep this in mind as a quick and dirty rule: A personal loan is often best for those who need money for a single large expense and know exactly how much they need. A personal line of credit is ideal for multiple large expenses that occur over a few years, with timing and total costs less certain.
Frequently asked questions
How does the draw period work for a personal line of credit?
A personal line of credit is typically made up of two periods: a draw period and a repayment period. The draw period begins upon account opening, allowing you to borrow, repay, and reborrow your credit line as often as you like. It can last several years before you are then obligated to repay your outstanding balance, either in monthly installments or all at once.
Which has a better interest rate: personal loan or personal line of credit?
Interest rates for both personal loans and personal lines of credit tend to be fairly similar. The big difference is that a personal loan offers a fixed rate, while a personal line of credit typically offers a variable rate—meaning your interest can rise or fall depending on factors such as market conditions and changes in the prime rate.
How do repayment terms differ between personal loans and personal lines of credit?
A personal loan’s repayment term is split into equal monthly installments (which include interest) throughout the term of your account. The repayment term of a personal line of credit will change based on the amount of money you use (similar to a credit card). During its draw period, PLOCs require only a monthly minimum payment, sometimes interest-only; during the repayment phase, you’ll be set up on monthly installments similar to a personal loan (unless you pay off your balance all at once).
When should I use a personal loan instead of a line of credit?
You should use a personal loan instead of a personal line of credit for a large purchase for which you need all the money upfront. A personal line of credit is better for multiple large purchases that you’ll make over a years-long period.
Can I pay off a personal loan or line of credit early without penalty?
In most cases, you can pay off a personal loan or line of credit early without penalty. Some lenders still charge a prepayment penalty, but it’s a rarity.