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A line of credit works differently than a loan but may be a great alternative when you need funds on an ongoing basis.
You’re probably familiar with how a loan works: Once your loan application is approved, you receive your loan money as a lump sum. You’re typically required to start making at least minimum payments and will pay interest on the money you’ve borrowed right away.
Lines of credit share some common qualities with loans but offer a different way to access cash and repay balances. If you’re deciding between a line of credit and a loan, whether for your personal finances or business, those differences are important to understand.
- What is a line of credit?
- Personal line of credit vs. personal loan
- Business line of credit vs. business loan
What is a line of credit?
A line of credit is essentially a reusable loan. You can borrow up to a certain limit, make minimum payments, pay interest, pay off your balance, and borrow again. You can repeat this process as many times as you like as long as your line of credit is open and in good standing.
You may be able to use funds from a line of credit by writing checks, using a card tied to the account, or requesting a transfer to your checking account. Even though the line gives you access to money up to a certain limit, you won’t be charged any interest until you borrow, or “draw,” from the available funds.
For unsecured lines of credit, you can only draw from the line of credit for a limited period of time, usually a few years, after which there is a repayment period in which you must pay off any remaining balance (typically, around three to five years).
Personal line of credit vs. personal loan
With a personal loan, you’ll begin accruing interest on the full loan balance right away and will be responsible for making fixed payments over a set period of time. With a line of credit, however, you won’t have to pay interest until you draw on the line, and you’ll only be charged interest on the outstanding balance you carry.
Having a line of credit means having access to funds you can use and repay over and over again within a certain time frame. This can be handy when it comes to big projects like a home remodel, where expected costs can shift. It could rid you of the hassle of having to find an extra source of cash when costs come up down the line.
You may, however, find it difficult to qualify for a line of credit if you don’t have the best credit, since approval usually requires that your credit be in good condition. If your credit is less than stellar, you may be able to find a personal loan you qualify for — just know that lower scores could mean higher interest rates.
Loans may be a better alternative for a number of other reasons too. They allow you to limit what you borrow to the amount you need upfront, rather than have an open balance you can draw on. And they offer the predictability of required regular monthly payments that you can budget for.
But debt could build up for lines of credit and loans if you are tempted to make just the minimum required payments while letting interest build. So before considering either option, make sure you’ll be able to repay the funds according to the terms.
Times when you may consider applying for a personal line of credit
- You’re not sure how much money you’ll need
- Your expenses may be spread out over a period of years
- Your credit is in good condition
Times when you may consider applying for a personal loan
- You know how much you need to borrow
- You want to limit the amount of debt you take on
Business line of credit vs. business loan
Both lines of credit and loans can be useful options when managing a business, depending on your business’s financial situation and individual needs.
A line of credit, however, may offer some major advantages over a loan. It’s one of the ways to access cash on demand, which can be crucial to the success of a business.
Lines of credit can also offer flexibility when it comes to monthly payments. Typically, you can make the minimum payment, pay the full balance or pay an amount in between. But keep in mind that you’ll pay interest on any balance you carry.
But business loans can still serve an important purpose. Loans can potentially be more cost-effective than lines of credit if you know exactly how much cash you need for a project or repair. With all your loan costs known up front, a business loan offers the ability to budget for both your total repayment cost and monthly payments. And if you make those planned payments responsibly, you can avoid allowing unexpected interest to build beyond your ability to pay.
Gerri Detweiler is the education director at Nav, a company that helps businesses build their business credit and find financing. Detweiler says that business owners should be ready to shop around before choosing between a line of credit or a loan.
“Every program is different,” she says, “so just because you can’t qualify for one type of small-business financing doesn’t mean you can’t qualify for anything.”
Times when you may consider applying for a business line of credit
- You need ongoing access to cash
- You need payment flexibility
Times when you may consider applying for a business loan
- You know how much you need to borrow
- You want set repayment costs
“If you take out a loan when you really need a line of credit, or vice versa, you may wind up paying more than necessary,” Detweiler says. “That’s because you may pay interest on money you don’t use, or you may be at a higher interest rate than you could have qualified for otherwise.”
Before applying for a loan or a line of credit, it’s important to consider how much financing you’ll need in the long and short term, as well as the condition of your credit, to help you make the best decision for you.