Loan vs. Line of Credit: An Overview
Loans and lines of credit are two different kinds of debt issued by lenders to both businesses and individuals. Approval for both loans and lines of credit—also referred to as credit lines—are dependent on their intended purpose, a borrower's credit rating and history, along with their relationship with the lender.
Loans have a nonrevolving credit limit which means the borrower only has access to the amount loaned once, making principal and interest payments until the debt is paid off. A line of credit, on the other hand, works differently. The borrower gets a set credit limit—just like 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 access to the funds.
- Loans and lines of credit are types of debt that depend on a borrower's needs, credit score, and relationship with the lender.
- Loans are nonrevolving credit facilities that are normally used for a specific purpose by the borrower.
- Lines of credit are revolving credit lines that can be used for everyday purchases or emergencies.
A loan comes with a specific amount based on the borrower's need, credit rating, and relationship with the lender. Like all nonrevolving credit products, a loan is granted 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 different forms: 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 collateral, sell it, and put it 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 collateral. In most cases, approval for these loans relies solely on a borrower's credit history and are generally advanced for lower amounts than secured loans.
Interest rates tend to vary based on the type of loan granted. Secured loans normally come with lower interest rates because of the low level of risk associated with them. Because most borrowers don't want to give up the collateral, they're more likely to keep up with their payments. Unsecured loans, though, often cost borrowers much more in interest. The rate also depends on the type of loan an individual or business takes out.
The following are just a few kinds 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, though, 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.
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 made 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 kind of debt used to fund 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. Payments are deferred while the student attends school and for the first six months after graduation.
These loans are also called commercial loans. These are special credit products issued to corporations—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.
On average, closing costs, if any, are higher for loans than for lines of credit.
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 credit limit which the person can use over and over again. This makes it a revolving credit limit, making them 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 like a credit card and, in some cases, like a checking account. Like a credit card, the individual can access the funds whenever they need them as long as the account is up to date and there's 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. Some credit lines also function as a checking account. This means you can make purchases and payments using a debit card, or even write checks against it.
Credit lines tend to have higher interest rates 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.
Like loans, there are many different kinds of lines of credit:
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, they 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.
Home Equity Line of Credit (HELOC)
Home equity lines of credit (HELOCs) are secured facilities commonly backed by the market value of a person's home. It 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 the 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.
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 line can be secured or unsecured based on how much credit is requested, and interest rates tend to be variable.