Loan vs. Line of Credit: What’s the Difference?

Choosing one over the other depends on why you need the funds

Reviewed by Thomas BrockFact checked by Jane MeachamReviewed by Thomas BrockFact checked by Jane Meacham

Loan vs. Line of Credit: An Overview

Loans and lines of credit (LOC) are two different ways that businesses and individuals can borrow from lenders. Their major difference is in how you receive the funds.

Loans have what’s called a non-revolving credit limit, which means the borrower has access to the funds only once, and then they make principal and interest payments until the debt is paid off.

A line of credit, on the other hand, works differently. The borrower receives a set credit limit—just like a credit card—and makes regular payments that include both principal and interest. Unlike a loan, the borrower has continuous and repeated access to the line of credit while it is active.

Approval for both loans, including personal ones, and lines of credit (also referred to as credit lines) is dependent on a borrower’s credit rating and financial history, along with their relationship with the lender.

Key Takeaways

• Loans and lines of credit are both types of bank-issued debt that serve different needs; approval depends on a borrower’s credit score, financial history, and relationship with the lender.
• Loans are best for one-time, fixed expenses, like a house or car.
• Lines of credit, which are revolving credit lines, are better-suited for projects or purchases that need flexibility and may be used repeatedly for everyday purchases or emergencies.
• Loans and lines of credit usually offer lower interest rates than credit cards for borrowers with good credit.

What Is a Loan?

A loan comes with a specific dollar amount based on the borrower’s need and creditworthiness. Like other non-revolving credit products, a loan is granted as a lump sum for one-time use, so the credit advanced can’t be used over and over again like a credit card.

Loans are either secured or unsecured. Secured loans are backed by some form of collateral—in most cases, this is the same asset for which the loan is advanced. For instance, a car loan is secured by the vehicle. If the borrower doesn’t fulfill their financial obligation and defaults on the loan, the lender can repossess the car, sell it, and put the proceeds toward the remaining loan balance. If there’s an outstanding amount, the lender may be able to pursue the borrower for the rest.

Unsecured loans, on the other hand, aren’t backed by any form of collateral. In most cases, approval for these loans relies solely on a borrower’s credit history. Because they are unsecured, there is no way for the lender to get their money back in the event of default, so these loans are generally for lower amounts and have higher interest rates than secured loans. (The exact rate will also depend on the type of loan an individual or business takes out.)

Secured loans normally come with lower interest rates because of their low level of risk. Because most borrowers don’t want to give up the collateral—for example, their home or their car—they are more likely to keep up with their payments. If they do fail to repay the loan, the collateral still retains much of its value for the lender.

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.

Important

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 cash against 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.

Read the original article on Investopedia.