Understanding Personal Loans and Lines of Credit

You can use a personal loan or a personal line of credit for just about any purpose, but depending on what you need to borrow money for one might be a better fit for you than the other.

With a loan (sometimes called an installment loan), you borrow a specific amount of money that you receive in one lump sum. Some installment loans involve collateral (such as a vehicle), while others require only your signature. The reason they’re often called installment loans is because you pay the amount you borrowed back in installments or monthly payments. The benefit of an installment loan is that you receive all the money up front and you know exactly what your payments will be and how long it will take you to pay the loan off. That makes an installment loan the best option for a one-time borrowing need. If you want to consolidate your debts or make a large one-time purchase (such as new furniture), a personal loan is a good choice.

A line of credit is similar to a loan in the sense that it involves borrowing money from a financial institution, but the way it works is a little different from a loan. With a line of credit, you get approved for a maximum amount of funding that you can borrow (like a loan) but you don’t have to receive all of the money at one (unlike a loan). Instead, a line of credit gives you the flexibility to borrow what you need, when you need it, up to the total amount you’re approved for.

Many lines of credit are considered revolving, which means you can borrow, repay, and borrow again. Think of it like a credit card: you have a total limit you’re approved for, and the amount you have available to borrow within that limit depends on the amount you already have outstanding. Compared to a credit card, a line of credit tends of offer much better rates and is better for larger purchase amounts (rather than day-to-day usage). That makes a line of credit a good choice when you expect to borrow money more than one time or if you know that you won’t need the entire amount up front. You might want to consider a line of credit if you’re making home improvements, paying for a wedding, or just want the option of having additional funding available to cover unexpected costs.

A lot of financial institutions also let you link your line of credit to your checking account to help protect against accidental overdrafts, which is something you can’t do with a loan. However, it’s important to keep in mind that the flexibility afforded by a line of credit also means less predictability in your monthly payments. With a line of credit, your payment will depend on the amount of money you have outstanding.

For both loans and lines of credit, you will be required to pay interest on the amount you have borrowed. With an installment loan, that means you’ll begin paying interest on the full amount you borrowed and pay interest on the amount you owe each month as you pay off your loan. With a line of credit, you’ll pay interest on the amount you’re actually using (not the full amount you were approved for). That’s another reason that a line of credit is a good option if you don’t need to use all of the funds up front.

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