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Personal Line of Credit vs. Personal Loan
If you’re considering personal loans vs. a personal line of credit, start by understanding the key differences between the two products. Both personal loans and personal lines of credit can be useful resources but picking the right one largely depends on how you intend to use the funds and how much money you need to borrow. The number of personal loans in the U.S. is on the rise, but only accounts for a fraction of outstanding consumer debt. Rather than blindly jumping on the bandwagon, consider how both types of financing work and which one makes sense for you.
What is a personal loan?
Personal loans are financing products that allow people to borrow a lump sum of money. The loan principal is repaid over a set period of time, which can vary, typically between six months and 12 years. Included in your payment is interest paid to the lender. You may also have a lender origination fee deducted before you actually receive the loan funds.
Your interest rate is determined by a number of factors, including your credit score. Standard personal loan rates can start as low as 6% APR and go up to 36% APR. According to the Federal Reserve, the average personal loan rate was 9.34% as of September 2020.
What’s a personal line of credit?
A personal line of credit is another financing option you can use for almost any purpose. Rather than receiving one-time funds as you would with a personal loan, you draw from a line of credit up to a certain amount. Interest only accrues when money is withdrawn. This type of revolving credit is similar to a credit card in that borrowers withdraw up to the balance limit and then repay to draw on the line again. Interest rates are on par with personal loans and terms typically start at a year and go up to seven years, depending on the lender.
Personal loan vs. personal line of credit
There are several major differences between personal loans vs. a personal line of credit. With a personal loan, you borrow a set amount and repay it over a fixed period of time. Your monthly payment is consistent, so it’s easier to budget and plan to pay off the balance in full.
With a line of credit, you’re able to continually borrow money over the course of the draw period, which can last years. Many lenders only require you to pay interest during this time. The repayment period begins once you draw period ends. That’s when you must start making payments on both principal and interest.
Most personal loans and lines of credit are unsecured, but some lenders may require some type of collateral. A home equity line of credit, for example, uses your house as collateral against the borrowed funds.
Which option is more popular? An Experian study reveals that personal loans are the highest-growing type of debt in the U.S., even eclipsing credit cards. However, both personal loans and lines of credit are easy to find among online lenders, allowing you to compare options without much hassle. SoFi, Best Egg and Payoff, for example, offer both types of consumer financing. Others like PenFed and LightStream only offer one type of financing, but may still be competitive options to consider.
How to qualify for a personal loan
Here’s how to qualify for a personal loan:
- Improve your credit score. This is the most important factor in qualifying for a lower interest rate on your personal loan. The better your credit score, the higher chance of approval and favorable interest rates.
- Request only what you need. When you apply for a personal loan, it’s up to you to determine how much money you need. If you’re borrowing above what you can reasonably afford to repay, then your personal loan application may be denied.
- Improve your debt-to-income ratio. The amount you’re allowed to borrow partially depends on how much current debt you have compared to your income. Lenders typically look for a maximum debt-to-income ratio of 50%, but some require a lower percentage. That means your total monthly debt payments must account for less than half of your monthly pre-tax income.
[ Next: What is a Good Credit Score Range? ]
How to qualify for a personal line of credit
Qualifying for a personal loan is quite similar to qualifying for a personal line of credit. Here’s how you qualify for a personal line of credit:
- Review credit score. Just as with a personal loan, you’ll receive a better interest rate and have a higher chance of approval if you have a good credit score. Line of credit lenders also look at your payment history to determine if you’re a good candidate for approval.
- Lower your credit utilization ratio. The amount you’re allowed to draw from will vary based on your existing debt. Your credit utilization ratio is a percentage of how much of your available credit you have used. For example, a credit card with a $5,000 limit and $1,000 charged to it will result in 20% credit utilization. Generally, your credit utilization ratio should be below 30%.
- Improve your debt-to-income ratio. Again, when you apply for a personal line of credit, your monthly debt payments shouldn’t be more than half of your pre-tax monthly income. If you can, consider paying off other debts first, like personal or student loans, before applying for a personal line of credit.
When should I choose a personal loan?
When comparing personal loans vs. a line of credit, think about how you plan to put your loan funds to use. Because personal loans typically come with lower interest rates than credit cards, many borrowers use them to consolidate debt. By putting multiple types of debt under one loan, you’ll benefit from having just one monthly payment to worry about. Plus, you may qualify for a lower rate and pay off your debt faster over a set period of time.
Other common uses for personal loans include paying off medical expenses, car repairs or other major expenses that may be difficult to cover in cash.
When should I choose a personal line of credit?
There are some situations when it may be better to finance your needs with a personal line of credit, especially if you don’t know exactly how much money you need. For instance, a line of credit may be used to finance a home renovation project. You may need to pay multiple contractors at different stages of completion, and even buy some materials directly on your own. With a line of credit, you only draw on the funds as you need them. That way, you’re not accruing interest for several months for money you don’t actually need.
You may also consider a line of credit if your work is seasonal and you need help with cash flow until your income picks up.
Personal loan vs. line of credit: Which one is better for you?
Choosing between loans vs. a line of credit largely depends on your needs. Start off by creating a plan for the funds you need. Do you have an exact dollar amount? Do you know the exact day you need to make a payment? If these details are concrete, then a personal loan may be better for you. But if you’re unsure or there are a lot of variables involved with your project, then having a line of credit on hand may be the way to go.
Of course, it’s also imperative to compare your loan and line of credit offers. For borrowers with bad credit, you may need to focus on bad credit lenders that cater to these types of financing.
Bad credit borrowers looking for a line of credit may need to provide some type of collateral, such as funds in a savings account or your home equity. Also check to see if your interest rate is going to be fixed or variable, since that will impact how much you owe over time.
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