How is a Line of Credit Different from a Loan?

If you’re facing an unexpected emergency without enough savings, one thing’s for sure: you need money, and you need it fast. What isn’t always clear is whether you should get that money from a line of credit or a personal loan.

How do you decide which one is the right one for your emergency? 

In a comparison between a line of credit vs loan, there isn’t a clear winner every time. It depends on your financial health and your borrowing needs. Let’s go over the biggest differences between these two options to help you decide.

Line of Credit Versus Loan: What Are the Differences?

Here are the biggest differences between a line of credit versus loan.

1. How You Use Your Funds

A line of credit (or LoC, for short) is a type of revolving product or open-ended loan. This simply means you’ll receive an available credit limit that you may draw against at any time.

You also don’t have to reapply for an LoC every time you pay off your charges. As a revolving product, your funds are available on a continuous basis as long as you pay back what you owe.

In contrast to an LoC, a personal loan is a closed-ended product. Generally, you’ll receive a personal loan in one lump sum, and you’ll have to repay it all back over a fixed payment schedule. If you need more money once you repay your loan, you’ll have to reapply.

2. How Interest is Applied

When it comes to an LoC, you may only pay interest and finance charges based on what’s borrowed — not your total limit available to you.

This is in stark contrast to a personal loan, where interest and finance charges are applied to the entire amount borrowed. These fees are generally a part of your scheduled payments.

3. How You Repay Your Loan

Another big difference between loan and line of credit options is how you repay the money you owe. When it comes to an LoC, your bill is based on what you use during that billing period, plus interest and finance charges.

You may also make what’s called a minimum monthly payment. This is generally made up of the following:

1.           Fees

2.           Interest

3.           Payment towards your principal (or the amount owing)

If you make a minimum payment, you’ll carry over a balance that’s subject to interest charges that may increase what you owe. As a result, it’s always a good idea to pay more than the minimum. Or, better yet, pay off your entire balance before it’s due.

As for a personal loan, you don’t have as much flexibility. You’re generally given a specific timeframe to pay back your amount owing, and you usually make fixed payments according to a schedule set out in your loan agreement.

What Should You Use?

In general terms, the flexibility of an LoC makes is a possible option if you need to cover several unexpected emergency bills that may change in size. You can tap into an LoC up to its limit any time you need more money.

A loan may be possible option if you’re expecting only a one-time emergency expense. You’ll receive the exact amount you need to cover this cost, and nothing more.

But at the end of the day, no one but you can make this decision. Whether one or the other is the right fit depends on your unique needs. Weigh the pros and cons of both options to find out which one you need for your emergency.