| Loan vs. Line of Credit | |
|---|---|
| Loan | Line of Credit |
| The borrower has access to the amount lent only once, in one lump sum. | A line of credit is a preset borrowing limit that can be used at any time, paid back, and borrowed again. |
| A loan is based on the borrower's specific need, such as the purchase of a car or a home. | Credit lines can be used for any purpose. |
| On average, closing costs (if any) are higher for loans than for lines of credit. | Credit lines tend to have higher interest rates than loans. |
| Interest accrues on the full loan amount right away. | Interest accrues only when funds are accessed. |
Types of Loans
The following are just a few common types of loans issued to borrowers by lenders:
Mortgage
A mortgage is a specialized loan used to purchase a home or other kind of property and it is secured by the piece of real estate in question. To qualify, a borrower must meet the lender's minimum credit and income thresholds. Once approved, the lender pays for the property, leaving the borrower to make regular principal and interest payments until the loan is paid off in full. Because mortgages are secured by properties, they tend to come with lower interest rates than other loans.
Automobile Loan
Like mortgages, automobile loans are secured. The collateral, in this case, is the vehicle in question. The lender advances the amount of the purchase price to the seller—less any down payments made by the borrower. The borrower must adhere to the terms of the loan, including making regular payments until the loan is paid in full. If the borrower defaults, the lender can repossess the vehicle and go after the debtor for any remaining balance. Often, car dealerships or the automaker will offer to serve as the lender.
Debt Consolidation Loan
Consumers can consolidate all their debts into one by approaching a lender for a debt consolidation loan. If and when approved, the bank pays off all the outstanding debts. Instead of multiple payments, the borrower is only responsible for one regular payment, which is made to the new lender. Most debt consolidation loans are unsecured.
Home Improvement Loan
Home improvement loans may or may not be secured by collateral. If a homeowner needs to make repairs, they can approach a bank or other financial institution for a loan to make renovations that will likely increase the value of their home.
Student Loan
This is a common form of debt used to fund qualified educational expenses. Student loans—also called educational loans—are offered through federal or private lending programs. They often rely on the income and credit rating of the student's parents rather than the student themselves—but it is the student who is responsible for repayment. Payments are typically deferred while the student attends school and for the first six months after graduation.
Business Loan
Business loans, also called commercial loans, are special credit products issued to small, medium, and large businesses. They can be used to buy more inventory, hire staff, continue day-to-day operations, or just as an infusion of capital.
In addition to interest, borrowers generally pay other charges for loans, such as application fees and loan origination fees.
What Is a Line of Credit?
A line of credit works differently from a loan. When a borrower is approved for a line of credit, the bank or financial institution advances them a set credit limit that the person can use over and over again, all or in part. This makes it a revolving credit limit, which is a much more flexible borrowing tool. Some credit lines may also include accordion features that allow access to increased levels of funding. Unlike loans, credit lines can be used for any purpose—from everyday purchases to special expenses, such as trips, small renovations, or paying down high-interest debt.
An individual's credit line operates much like a credit card, and in some cases, like a checking account. Similar to a credit card, individuals can access these funds whenever they need them, as long as the account is up to date and there is still credit available. For example, if you have a credit line with a $10,000 limit, you can use part or all of it for whatever you need. If you carry a $5,000 balance, you can still use the remaining $5,000 at any time. If you pay off the $5,000, then you can access the full $10,000 again.
Credit lines tend to have higher interest rates, lower dollar amounts, and smaller minimum payment amounts than loans. Payments are required monthly and are composed of both principal and interest. However, lines of credit typically carry lower interest rates than credit cards for borrowers with good credit.
Additionally, lines of credit usually impact consumer credit reports and credit scores much faster and more significantly. Interest accumulation begins only once you make a purchase or take out cashagainst the credit line.
Note
Some credit lines also function as checking accounts. This means you can make purchases and payments using a linked debit card or write checks against the account.
Types of Credit Lines
The three common types of credit lines are personal, business, and home equity:
Personal Line of Credit
This is an unsecured line of credit. Just like an unsecured loan, there is no collateral that secures this credit vehicle. As such, these require the borrower to have a higher credit score. Personal lines of credit normally come with a lower credit limit and higher interest rates. Most banks issue this credit to borrowers indefinitely.
Business Line of Credit
These credit lines are used by businesses on an as-needed basis. The bank or financial institution considers the company's market value and profitability as well as the risk. A business credit line can be secured or unsecured, based on how much credit is requested, and interest rates tend to be variable.
Home Equity Line of Credit (HELOC)
Home equity lines of credit (HELOCs) are secured credit facilities primarily backed by the market value of your home. A HELOC also factors in how much is owed on the borrower's mortgage. The credit limit for most HELOCs can be as high as 80% of a home's market value less the amount still due on your mortgage.
Most HELOCs come with a specific drawing period—usually up to 10 years. During this time, the borrower can use, pay, and reuse the funds over and over again. Because they're secured, you can expect to pay lower interest for a HELOC than you would for a personal line of credit.
Do Loans Have To Be Secured with Collateral?
Loans can either be secured or unsecured. Unsecured loans aren't backed by any collateral, so they are generally for lower amounts and have higher interest rates. Secured loans are backed by collateral—for example, the house or the car that the loan is used to purchase.
What Are the Disadvantages of a Line of Credit?
Although lines of credit can be used over and over again like credit cards, they tend to have higher interest rates and lower dollar amounts.
Can a Loan Be Used Like a Credit Card?
A loan is a non-revolving credit product, so it can't be used like a credit card. Because it is a lump sum for one-time use, the credit advanced can't be used over and over again.
The Bottom Line
Both loans and lines of credit are essential tools to stimulate economic growth. For ongoing credit needs, revolving credit sources like credit cards or line of credit are the most useful, but may come with higher interest rates and increased fees. Loans may have higher upfront fees but could cost less in the long run. Evaluate your credit needs before applying to find the best fit.
