Personal loan vs. personal line of credit

How are personal loans and lines of credit different?

“A personal loan is like taking the stairs, while an LOC can be like hiking an unknown trail,” said Melissa Anne Cox, CFP at Fetterman Investments in Dallas.

Use a personal loan to consolidate credit card debt, and you could be trading in a 24% interest rate for one that is more like 11%.

One major difference in how the two types of loans work is the type of interest rate they use: Personal loans typically carry fixed interest rates, while LOCs generally have variable rates. Those interest rates ultimately affect your monthly payment.

Interest rates

If your personal loan has a fixed interest rate, as most do, your payment won’t change throughout the loan term. Interest rates for personal loans typically range from 3% to 36%, with an average rate of 10.5% at the time of publishing. How much interest you pay generally depends on your credit score and the amount you're borrowing. Compare reviews to find a rate that’s right for you.

LOCs often have variable interest rates that change over time based on an indexed rate. Most LOC rates fall between 9.3% and 17.55% (check out our top four picks for loans with low interest).

Payments

Another difference is how the payments work. Personal loans generally have fixed payments (as long as you have a fixed interest rate). Those payments contribute to both interest and principal. Since LOCs have variable interest rates and let you draw an irregular amount of funds each month, payments can go up and down from month to month.

In addition, LOCs are similar to credit cards in that you often have a minimum monthly payment that may only be a fraction of what you owe. Interest accrues from the moment you draw funds, so you could rack up a large interest total if you only make the minimum payment. Like credit cards, minimum payments generally contribute to paying off interest, not the amount borrowed.

“My advice to someone that has financed a purchase is to not pay just the minimum payments,” said Cox. “Reduce the principal or borrowed amount by creating a plan to pay the debt faster.”

Term length

LOCs typically let you borrow funds for a longer period of time. Some LOCs have draw periods of up to 10 years or more, as long as you make on-time payments. Personal loans tend to be shorter-term financing with maximum loan terms of up to five years.

Fees

You could pay up to 10% of the total loan amount in origination fees, and LOCs tend to have annual fees, at least during the draw period. These fees range from $25 to $50 a year. “There is a cost to borrowing or financing a purchase,” explains Cox. “And lenders want to be accommodated for their potential risk.”

Funds disbursement

Yet another difference is the way you receive the money. While both financing options let you use funds for just about anything, including emergencies, home improvement projects, etc., personal loans are better for projects with a known cost since you receive all the money in a lump sum.

For example, if you plan to consolidate your credit card debt into one monthly payment, you may opt for a personal loan. An LOC, however, can be used for projects that have undetermined costs or that may occur in stages.

Some homeowners choose to use an LOC to finance home improvement projects they plan to make in the near future but may not have a set cost for just yet.

You can get an LOC but not draw on the funds until you are ready to make purchases. In these cases, you won’t have a payment due until you receive funds from the LOC. You could use LOC funds to buy a new washer and dryer today, then replace your kitchen appliances a few years later.

However, once you take out a personal loan, repayment on the total begins immediately because the funds are disbursed upfront.

Why it's important to know the difference

When a reviewer on our site from Ohio was facing costly window replacement, Champion Windows hooked him up with financing — a line of credit from a third party. He didn’t think too much about it at the time. “All my windows are Champion windows,” he says. “I bought just a few at a time because they're kind of cost-prohibitive. But I really wouldn't have anything else.” Because he didn't know the difference between the two products, he didn't realize what he was getting until he'd already signed for the line of credit.

According to Andrew Rosen, CFP and President of Diversified, LLC in West Chester, Pennsylvania, “With a personal line of credit, the credit is revolving and you’re accumulating interest on an unpaid balance, and the interest rates may be variable, which can result in monthly payments that vary widely from month to month because the amount you owe is constantly changing.”

“That is not what I call a simple interest note,” the reviewer said. “A simple interest note, I would borrow $3,500 and I would pay this amount of interest and that would be it. This has not been my experience in the past.”

The “simple interest note” he's describing from his past is a personal loan. 

“If you’re someone who prefers a set budget, a personal loan may be a better option than an LOC,” said Rosen. “Particularly if you have a good idea of the total cost of the project or need that you have upcoming. For projects where the cost may vary, an LOC would work better.”

Personal loan vs. line of credit

If you're deciding between taking out a personal loan and a line of credit, it's crucial to understand how each works. While they share many features, there are some significant differences.

How are personal loans and lines of credit similar?

While there are multiple differences between personal loans and lines of credit, the two types of funding also have many similarities, including credit and collateral requirements and availability.

Credit requirements

Lenders have similar borrower requirements for personal loans and LOCs. First, you probably want to have a credit score of at least 670 to get a decent rate. If your credit score is lower than that, your options will be limited, and you may have to pay more in interest.

You also likely need a debt-to-income (DTI) ratio of 35% to 40% or lower. Lenders look at your overall financial situation, including your income and credit history, to determine if you're eligible for financing and what interest rate you qualify for.

Availability

Personal loans and LOCs are widely available from various lenders. You can apply for either type of financing from banks, credit unions or online lenders. Rates and other loan terms vary by lender.

Collateral

Most personal loans and personal LOCs are unsecured, which means there are no collateral requirements. However, some lenders offer secured options that can help those with less-than-perfect credit qualify for financing. In addition, secured loans generally have lower interest rates than unsecured loans. Collateral could be a savings account, CD (certificate of deposit) or money market account.

Loan amount

You can potentially secure anywhere from $1,000 up to $100,000 with a personal loan or LOC. However, the loan amount you qualify for is based on personal factors like credit history and income.

Which is better for you?

As it turns out, our reviewer from Ohio might have preferred a personal loan when purchasing his windows. “There is a fixed interest rate when borrowing the funds and many like the stability of a fixed monthly payment when considering their monthly budgets or spending plans,” Cox said about this type of loan. 

A personal loan is generally better for situations where you know the total cost of your purchase or project ahead of time. An LOC, however, is often a good option when you aren’t sure how much money you'll need. Also, an LOC can accommodate multiple purchases over a long period of time.

“They’re a good alternative to high-interest credit cards,” said Rosen.

Personal lines of credit may only require a minimum payment to cover interest — be sure to make more significant payments to avoid collecting more debt than you can handle.

Benefits of a personal loan

“The rise of Fintechs has made getting a personal loan easy,” said Joel Ohman, CFP and CEO of Clearsurance. “Instead of applying in person at a bank, people can apply online and get almost instant approval. As a result, it’s so easy to get a personal loan that people can get one on a whim.”

Most personal loans carry fixed interest rates, so monthly payments generally don’t change over time. That means you can budget your payments accordingly without worrying about a sudden increase. In addition, average interest rates tend to be lower on a personal loan than with an LOC, so you’ll likely pay less in interest overall.

A personal loan may be better for a single, large purchase because you can pay back the loan in equal payments over time. The best uses for a personal loan are projects that have reliable, upfront cost estimates.

For example, if you plan to remodel your kitchen, the contractor may give you a quote for the project's total cost. Or, if you plan to consolidate your high-interest credit card debt, you can add up the totals of your accounts to get the amount you should borrow.

Benefits of a personal line of credit

A personal LOC allows for on-demand use, so you won’t have to pay back anything you didn’t need to borrow in the first place. Some projects require smaller expenses here and there, making an LOC a better option to avoid paying interest on money you don’t need yet.

LOCs may also have longer term lengths, which mean you could spread out your project over time to better accommodate your budget. In addition, an LOC may be better suited for unexpected situations that are costly, like relocation for a new job or home repairs.

Where to get a personal loan or line of credit

You can get a personal loan or LOC from multiple lenders, including banks, credit unions and online lenders. You can start by requesting a quote from the financial institution you currently use for most of your banking needs — the established relationship could earn you a lower rate.

As you do your research, be sure to gather quotes from several lenders to compare the costs of each option. Some lenders may not charge upfront fees but might have higher interest rates.

You can start by comparing each option by the annual percentage rate (APR), which is the interest rate with fees and charges included. Your APR gives you an overall picture of the true cost of credit.

Bottom line: Lump sum purchase or multiple purchases over time?

Both personal loans and lines of credit can be good options if you need access to funds. However, personal loans are usually better for large purchases, especially if you know upfront about how much the purchase will cost. You don’t want to borrow more money than you need to use; otherwise, you’ll pay more interest than necessary. With a personal loan, you’ll receive the funds in a lump sum and begin repaying the loan immediately.

A personal line of credit can be helpful if you need to make several purchases without a set cost estimate. An LOC lets you spend only what you need at the time. You may feel temptation to overspend with on-demand credit like this, however, so be aware of how your purchases will affect your payments and your overall budget.