What’s the difference between a loan and a line of credit?
Depending on your financial journey, there may be times when borrowing money makes sense. But what type of credit option you choose will depend on your goals and what you need the money for. Not sure what the difference is between a loan and a line of credit? This breakdown should help.
What is a loan?
A loan is a specific amount of money provided to a borrower (you) by a lender. Loans are provided based on a particular need (think a mortgage or car loan) and the borrower's creditworthiness.
Here are some examples of typical loans for specific needs:
- Debt consolidation
- Home improvement
Loans are lump-sum amounts provided for one-time use. They are not revolving credit. The interest begins to accumulate on the total amount immediately once the loan is advanced.
Payments on loans include a portion that goes to interest and a part that goes towards paying down the principal.
Benefits of loans
When comparing loans to lines of credit, loans have specific benefits.
Lower interest rates
Loans typically have lower interest rates than lines of credit. Because they are more of a fixed product, loans can be less risky to lenders, impacting the interest rate they are willing to lend at.
The interest rate you have access to as a borrower will depend on your credit score; the better your score, the lower the interest rate.
Greater borrowing capacity
With a loan, you will have access to more money than with a line of credit.
Let's look at borrowing money against a home as an example. With a mortgage (loan), you can borrow up to 95% of the property's value (with certain conditions). But with a home equity line of credit, you can usually only borrow up to 65% of the appraised value. There are some conditions when that amount may be as high as 80%, but it still falls short of the 95% of the value the loan offers.
Like any lending product, the amount you will have access to from a lender will depend on your credit score.
Access to money all at once
A loan advances all of the funds at once. This can be an advantage if you need access to all of the money immediately. When buying a car or paying for post-secondary, having access to all the funds at once is very important.
Less self-discipline required
Even though loans can have variable or fixed rates, the payments are created based on a fixed payment schedule.
Because interest begins to accrue on the entire loan amount immediately, there are no fluctuations based on access to funds. You cannot access any more money than the total amount, so you don't need the self-discipline to spend or use the borrowed funds.
More products available
As listed above, there are many different types of loans. Loans offer more products than lines of credit. In this way, loan products are more flexible than lines of credit.
Drawbacks of loans
Sometimes loans are not the superior product when compared to lines of credit. Here are the drawbacks to consider before signing up for a loan.
Higher closing costs
Not all loans have closing costs, but if they do, they are typically higher than costs associated with establishing a line of credit.
Interest accrues immediately
With a loan, interest on the entire borrowed amount begins to accrue immediately. This is different from a credit line or credit card and may end up costing you more interest charges throughout the term of the loan.
Loans are less flexible than lines of credit. The money advanced in a loan applies to a specific purpose.
It would be complicated (if not impossible) to get an automobile loan that you could use for home renovations.
A loan advances the total lump sum of money all at once. It is all or none. This is a disadvantage if you don't need the money all at once because whether you need it or not, interest will be charged on the entire amount right away.
May repossess collateral
With a secured loan, such as a mortgage or automobile loan, if you stop making payments, the lender can repossess the collateral. This repossession is doubly harmful as it will also impact your credit rating.
Secured vs. unsecured credit
Loans and lines of credit can be both secured or unsecured.
Collateral, such as property or a vehicle, secures a secured product. Because of this collateral, secured products are less risky to lenders and often come with lower interest rates and higher borrowing amounts.
The creditworthiness (credit report and score) of the borrower determines the funds lent for unsecured products. The stronger the customer, the less risk there is to the lender.
Unsecured products typically have higher interest rates and lower borrowing amounts. A personal line of credit is an example of an unsecured product.
What is a line of credit?
A line of credit is a form of revolving credit. The lender sets a credit limit, and the borrower can borrow up to the credit limit amount similar to a credit card.
As long as the line of credit is open, you will have continuous access to the funds. And you only have to pay interest on the amount you use, not the entire credit limit amount. But the total credit amount counts towards your debt service ratio.
Your minimum payment may or may not include principal repayment.
Pros of a line of credit
Lines of credit come with some advantages over loans.
Only pay interest on amount used
One benefit of a line of credit is that you only pay interest on the amount that you use. For example, if you have a $10,000 limit but only require $3000 right now, you only pay interest on the $3000 withdrawal.
As long as the line of credit is open and in good standing, you will have access to the funds. So, if you have that same $10,000 limit mentioned above and use $10,000, once you pay back $2,000, you will then have access to those funds again for another use in the future.
Don't need to withdraw total amount all at once
While the funds for a loan are advanced all at once, the same is not valid for a line of credit. Once the line of credit is open, you have access to all of the funds. But you don't have to withdraw them all at once if you don't need to.
You may choose to use your credit line as an emergency fund that you can access when needed, time and time again.
You can open a line of credit without a specific purpose. Once you open the credit line, you can use the funds for whatever you want. And depending on their use, you may even be able to deduct the interest on your taxes.
Smaller minimum payments
Some credit lines, especially those that are secured, only require interest payments as minimum payments. These minimum payments will not help you get ahead in repaying the principal but can help your monthly budget if funds are short.
Cons of a line of credit
Before you jump in and apply for this credit option, here are some cons you should be aware of.
Lower borrowing amounts
Typically lines of credit have lower borrowing amounts. Look back at the example above related to the difference between home equity lines of credit and mortgages for clarity on this.
Higher interest rates
Although the interest rate is often related to the prime rate, an additional premium applies to the prime. Whereas a loan may have an interest rate of a prime minus 0.5%, the interest rate on a line of credit may be prime plus 0.5%.
You don't need self-discipline with a loan as the funds apply to a specific purpose. When you get a line of credit, you can use the funds at any time. Without self-discipline, it can be easy to overspend and just fall back on your available credit. Self-discipline is required so that you only use the funds for their intended purpose.
Impact on credit utilization and credit score
Even though interest only applies to the amount of your credit line that you are actually using, the whole amount counts towards your debt service ratio. And the more of the line of credit you access, the more significant the impact it will have on your credit utilization.
Both your debt service ratio and credit utilization can directly impact your credit score.
Not best for lump sum
If you need all the funds simultaneously, then a loan is a better option due to the lower interest rates.
Line of credit vs. loan – Which one is best?
Choosing between credit options will depend on your personal circumstances and goals.
A loan is a good choice if:
- You need access to a large amount of money all at once for a specific purpose
- You prefer set payments that won't fluctuate drastically
- Accessing the lowest interest rate possible is important
Whereas a line of credit may be your best choice if:
- You are self-disciplined
- Flexibility is important
- You have numerous or repetitive uses for the funds