Loan vs. Line of Credit: An Overview
A loan and line of credit are two different ways that businesses and individuals can borrow from lenders. Loans have what's called a non-revolving credit limit, which means the borrower only has access to the amount loaned once, and they subsequently 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 with a credit card—and makes regular payments composed of both a principal and interest portion to pay it off. But unlike a loan, the borrower has continuous and repeated access to the line of credit while it is active.
Approval for both loans and lines of credit (also referred to as credit lines) are dependent on a borrower's credit rating and financial history, along with their relationship with the lender.
- Loans and lines of credit are types of bank-issued debt that depend on a borrower's needs, credit score, and relationship with the lender.
- Loans are non-revolving, one-time lump sums of credit that a borrower normally uses for a specific purpose.
- Lines of credit are revolving credit lines that can be used repeatedly for everyday purchases or emergencies in either the full limit amount or in smaller amounts.
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 can come in two general forms: 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, are not backed by any form of collateral. In most cases, approval for these loans relies solely on a borrower's credit history and is generally advanced for lower amounts, and with higher interest rates, than secured loans.
Secured loans normally come with lower interest rates because of the low level of risk associated with them. Since most borrowers do not want to give up the collateral, they are more likely to keep up with their payments—and if they do fail to repay the loan, the collateral still retains much of its value for the lender. Unsecured loans, though, often cost borrowers far more in interest. The rate will also depend on the type of loan an individual or business takes out.
|Loan vs. Line of Credit|
|Loan||Line of Credit|
|The borrower only has access to the amount loaned 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 need, such as purchasing 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:
A mortgage is a specialized loan used to purchase a home or other kind of property and is secured by the piece of real estate in question. In order 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.
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 then is only responsible for one regular payment, which is made to the new lender. Most debt consolidation loans are unsecured.
Home improvement loan
These loans may or may not be secured by any collateral. If a homeowner needs to make some repairs to their home, they can approach a bank or other financial institution for a home improvement loan. It allows the homeowner to take out funds to make much-needed renovations.
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 student's parents' incomes and credit ratings and not the students', although the student becomes responsible for repayment. Payments are typically deferred while the student attends school and for the first six months after graduation.
These loans are also called commercial loans. Business loans are special credit products issued to businesses—small, medium, and large—to help them buy more inventory, hire staff, continue day-to-day operations, or when they just need 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, a much more flexible borrowing tool. Unlike loans, credit lines can be used for any purpose—from everyday purchases to special needs 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 to use. So, 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, you can then 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. Lines of credit usually create more immediate, larger impacts on consumer credit reports and credit scores. Interest accumulation only begins once you make a purchase or take out cash against the credit line.
Some credit lines also function as a checking account. 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 commonly 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 owing 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.