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When you need or want to buy something that exceeds your available funds, it is common to borrow money from elsewhere. If you cannot get it from your friends and family, the next practical solution is to request the funds from a bank or lender. However, most consumers are unaware that there are several borrowing options, including a loan or a line of credit. Ultimately, the differences between these financial products help you determine which is best for your situation.
What is a loan?
A loan is a specific dollar amount provided by one person, business, or financial institution to another person or business in exchange for a promise by the borrower to pay interest and the balance of the loan in full on the agreed date. This is a fixed amount of money earned for one-time use. There are many types of loans, including mortgages, personal loans, auto loans, home loans, student loans, payday loans, and installment loans. A little research on the Internet can help you discover what is the difference between a payday loan and an installment loan or the difference between a mortgage and a home equity construction loan.
What is a line of credit?
A credit line is a form of lending in that it is financing from one person or entity to another. However, lines of credit are a fixed amount that can be used as often as the borrower needs (or until the account is depleted).
What is the difference?
While the definitions of loans versus lines of credit give you an overview of their differences, let’s dig a little deeper into how these financial products vary.
- Frequency of use – The most significant difference between a loan is their frequency of use. A loan is non-revolving, meaning you can only use the borrowed amount once. You must then repay the loan in full and apply for another one if necessary. A line of credit is revolving, which means you can use the amount borrowed, pay off the balance, and use it as many times as you want.
- Need of the borrower – Although personal loans can be used for any purpose, other loans are for a particular need. For example, a mortgage is used to buy a house, an auto loan buys cars, and student loans finance tuition. On the other hand, you can use a line of credit to finance anything.
- Increased interest – As soon as you receive a loan, interest begins to accrue. However, a line of credit does not earn interest until you start spending from the account.
- Refund – When you accept a loan, you must start paying the balance plus interest immediately until you meet your obligation. With a line of credit, no payment is required until you have spent the money. Plus, you only pay for what you use with a line of credit instead of owing the entire balance.
Which should you choose?
How do you know if you need a loan or a line of credit? Here are two factors to consider:
- Financial needs – The first thing to consider is why you need the money. If you are trying to buy a house, a car, or pay for college, a loan may be the best option, as you can apply for specific loans that will pay you larger lump sums to acquire those important investments in life. However, if you live paycheck to paycheck and want a financial cushion, often need extra money for purchases or to meet day-to-day expenses (e.g. dental procedures, tuition (beyond tuition), etc.), a line of credit would be ideal.
- Affordability – While having debt can be a good thing, too much debt can cause problems. Therefore, you want to select the most affordable borrowing option. For example, a bank may offer lines of credit at 12% APR or 1% monthly interest. However, a personal loan can range from 10% to 36%. You don’t have to worry about paying off a line of credit if the balance is zero; however, once you have taken out the loan, you must pay the required interest rate and the balance in full. If you’re trying to save money and avoid getting too deep in debt, a line of credit might be a better option.
When you find yourself in a traffic jam or simply make a major purchase in life, applying for a loan or line of credit is often the fastest way to reach your goals. I hope the information provided above has given you a better understanding of their differences, benefits, and common uses so that you can decide which is best for you.