Sometimes you could use a little more money. Maybe you need help with moving costs or buy yourself a new set of wheels. Or maybe you just want to consolidate your debts into one easy-to-manage place.
If you need funds, a personal loan or personal line of credit may be a good option. Although they have similarities, they are distinct products with advantages and disadvantages. It is important to understand how these products work before applying them.
Personal loan vs personal line of credit
A personal loan provides a lump sum that you can use immediately and then repay in fixed installments over a set period of time. A personal line of credit is a form of revolving credit that works much like a credit card. You are generally able to access funds up to a limit during the loan drawdown period, and you must repay any amount you borrow with at least minimum monthly payments.
Both types of debt are generally unsecured, meaning they are not backed by collateral such as a house or car. There are other key similarities and differences between personal lines of credit and personal loans in how you can access each and ultimately repay each.
How to apply for a personal loan or personal line of credit
The application processes for personal loans and personal lines of credit are similar.
“You will go through a relatively standard application process online or via a paper application, and depending on the provider, you will most likely be required to provide verification of income with a W-2 and/or pay stubs,” says Ted Braun. , vice-president. and Financial Advisor at Wealth Enhancement Group.
You can often prequalify for a personal loan or line of credit with just a soft credit application, but a rigorous credit check will be required once you’ve processed your application.
Rigorous credit checks can lower your credit score by up to five points, but keep in mind that credit inquiries for the same type of loan will be counted as one if you do your rate research within a short period of time. of time.
How to qualify for a personal loan or personal line of credit
There are some common factors you should expect lenders to consider if you are applying for a personal loan or line of credit.
“Credit score, income and the amount you’re looking to borrow will all determine the likelihood of you receiving a loan or line of credit,” says Brandon Ashton, director of retirement security at Cornerstone Financial Services. “A lender may also want to know your debt-to-equity ratio, your recurring monthly debt, whether you rent or own your primary residence, and how long you’ve been with your employer.”
You will generally need at least good credit to qualify for a personal line of credit. This means a credit score of 670 or higher.
In the meantime, you may be able to get a personal loan with fair or poor credit, but at lower rates. If you have bad credit or no credit history, you may need to get a co-signer for a personal loan, Ashton says.
Use and repayment of personal loans and personal lines of credit
Where personal loans and personal lines of credit really start to differ is in how you receive the funds and repay them. As mentioned, personal loans provide a lump sum, while you can choose how much to borrow on a personal line of credit, up to a limit.
Paying off a personal line of credit is much like paying off your credit card balance. “You borrow money as needed and make at least the minimum monthly payments each month,” says Daniel Rodriguez, chief operating officer at Hill Wealth Strategies. This means you won’t owe anything on your line of credit until you start using it.
With a personal loan, on the other hand, you will receive the full amount of the loan up front and then repay it in fixed installments over a predetermined period of time. “This allows for a steady cadence of payments and a more structured way to repay the loan,” says TJ Duffy, head of personal loans at TD Bank.
Generally, personal loans will have fixed interest rates, while personal lines of credit will have variable rates. This means that monthly payments on a line of credit will vary depending on factors such as how long you want to take to repay the amount borrowed and changes in interest rates during that time, Duffy says.
“Personal lines of credit generally have higher interest rates because the lender is assuming greater risk,” Rodriguez explains.
Make sure you understand terms such as the length of the drawdown period, or how long you’ll have to access the funds, before accepting a personal line of credit, Braun says. “At the end of the drawdown period, the line will be amortized into a fixed rate loan with a clearly defined repayment period.”
Repayment requirements and the length of the recovery period may vary, so check the terms of your line of credit. You also want to confirm any interest rate caps or lack thereof, Braun says.
How to choose between a personal loan and a personal line of credit
You can use a personal loan or personal line of credit for a variety of reasons. Either can be used to consolidate debt, pay for a wedding, fund home improvement projects or vacations, or even cover short-term emergencies, Ashton says. That said, each has uses it is best suited for.
“A personal loan is typically used when you have a specific need and know the loan amount in advance,” says Duffy. “The advantage would be a fixed payment with a fixed rate over a fixed period of time,” which makes budgeting much easier.
You can also use personal loans to consolidate higher interest rate debt into one fixed monthly payment.
“Let’s say, for example, that you’ve run up a few credit card balances and potentially have a car loan that’s coming to an end with a high payment,” Braun says. “You could use the personal loan to pay them off and end up with a lower monthly payment.”
Braun cautions against entering what he calls a “reload cycle” where you consolidate debt into a personal loan and then make more purchases on your credit cards. “It can be a vicious cycle to break once you get into it,” he says.
Personal loans can be particularly advantageous because interest rates are rising by allowing you to lock in a fixed rate, says Duffy.
In the meantime, a personal line of credit may be preferable if you’re not sure how much you’ll ultimately need to borrow.
“A line of credit provides consumers with the ability to access cash for unexpected events or when funds will be needed over an extended period, such as for an extended home improvement project,” Duffy said.
Braun says personal lines of credit are most useful in what-if scenarios, when you know you’ll need more money than you have, but don’t know how much more. “A personal line allows for flexibility when you’re unsure of how much you might need,” he says.
Preparing for success with either product means understanding the terms and making sure you’ll be able to pay off the debt on time.