What’s the difference between a loan and line of credit?

Did you receive an offer for a loan and line of credit and you’re trying to decide which one to go with? There are pros and cons of each, and what you choose will depend on your unique situation. In this article we’ll look at the difference between the two to help you decide which one is right for you.

A loan is a sum of money that you borrow for a specific purpose. With a loan, you’re required to pay it back based on an agreed upon payment schedule. When you agree to the terms of the loan, you’re agreeing to the period of time you’re required to pay back the loan. You’re also agreeing to the amount and frequency of each payment (i.e. weekly, biweekly, semi-monthly, monthly, etc.).

There are two main types of loans. A loan for personal purposes is called a personal loan. While a loan for business purposes is called a business loan. Besides that, there are several subsets of loans.

Secured Loan

A secured loan is one that has a valuable asset backing .– like your home or car. The assets act as collateral or security. If the lender isn’t paid back according to the terms and conditions of the loan and considers you in default, it can sell the underlying asset to help recover the money. Because it has an asset backing it, secured loans are considered less risky for lenders and, therefore typically come with a lower interest rate than the next type of loan we’re going to talk about.

Unsecured Loan

An unsecured loan works a lot like a secured loan. It’s a sum of money that you borrow for a specific purpose. Except it has one key difference. It’s not secured by an underlying asset, such a home or vehicle.

For that reason, lenders see unsecured loans as riskier. With a secured loan, the lender could sell the assets to recover most or all the funds it’s owed. With an unsecured loan, there is no asset for the lender to sell. If the borrower uses the proceeds of the loan and has little in the way of assets to show for it, the lender may have little recourse to recover the funds. Any missed or late payments show on your credit report and can impact your credit score. And the lower your score, the less likely you are to see offers (for things like loans and credit cards) that work for you. If the lender can't recover the money from you, they might use a debt recovery agency – so it's important to make sure you can afford repayments.

A line of credit is a type of loan that lets the borrower withdraw funds up to an agreed credit limit. Lines of credit can be both secured and unsecured. Lines of credit that are secured are backed up by an asset, such as a home. Credit lines that are unsecured don’t have any assets backing them up.

For that reason, the credit limit and interest rate tend to be different for each type. With an unsecured line of credit, the credit limit tends to be up to $50,000. If you want to borrow more than that, usually you’re required to take out a secured line of credit.

With a secured line of credit, the credit limit tends to be higher. Usually, the credit limit is far greater than $50,000, although it doesn’t have to be. The most common type of secured line of credit is a home equity line of credit (HELOC). With a HELOC, the government lets you borrow up to 65% of your home’s value if you have the income to qualify. Credit lines, whether secured or unsecured, offer the utmost in flexibility. A line of credit is a revolving account, similar to a credit card. You also don’t usually need to have a specific purpose when you apply for an unsecured line of credit. You can have an idea about why you want to borrow the funds, but you usually don’t need to tell that to the lender.

If you’re borrowing a large sum of money as a HELOC, the lender will usually want to know what you plan to use the money for.

The difference is mainly how you receive and pay back the money.

A loan tends to be very rigid. You receive all the money up front, and have to pay it back based on a repayment schedule.

With a line of credit, you’re approved to borrow up to a preset limit and can withdraw the funds when needed.

The interest rate of a loan can be fixed or variable. If you’re looking for the safety and security of knowing what your payment is going to be, you can go with a fixed rate. Otherwise, you can go with a variable rate, which is usually lower, although keep in mind that rates can rise.

With a line of credit, the rate is usually variable. A variable rate changes with the market, so it rises and falls. That means that you could see your payment jump due to a rise in interest rates. Although a benefit of a line of credit is that you are often able to make interest-only payments. This means that it can be a lot more flexible from a cash flow standpoint versus a loan, where you’re usually required to make payments that are made up of interest and principal, which tend to be a lot more costly.