Line of Credit vs. Loan: Understanding the Key Differences
When exploring different financing options, two popular choices often arise loans and lines of credit. Both options can fund your financial needs, but they differ significantly regarding features and benefits. This blog will delve into what loans and lines of credit are, their differences, and their respective benefits.
By the end, you’ll better understand which option is better for you.
What Is a Loan?
A loan is an amount you borrow from a bank, lender, or other financial institution. This borrowed amount can be used for various purposes such as purchasing a home, financing a car, medical expenses, weddings, education, and more.
When you take out a loan, the bank charges you interest on the borrowed amount, and you must repay it in fixed monthly installments known as EMIs. These EMIs consist of the interest amount and the principal repayment. Each month, a portion of your payment goes towards interest, and the rest towards principal repayment. If you want to know how much of your monthly EMI goes towards interest and how much toward the principal, check the loan amortization schedule.
What Is a Line of Credit?
A line of credit is a revolving credit facility where your bank provides a credit limit based on your credit history. With this credit limit, you can access funds whenever needed and fulfill your financial requirements.
Unlike loans, there is no fixed repayment schedule; instead, you must pay back only the amount you use by the next month’s due date. Your credit limit is restored once you repay the amount, and you can use it again. It is typically used for short-term borrowing, such as utility payments, shopping, etc.
Types of Loans and Lines of Credit
Loans and lines of credit can be classified into two broad categories: secured and unsecured. Let’s understand each category in detail.
Unsecured
Under an unsecured loan/line of credit, you do not have to keep any asset as collateral for the bank or any other lender. In case of non-payment, the lender cannot seize any asset to recover the loan amount.
– Unsecured Loans: Personal loans, education loans, wedding loans, etc.
– Unsecured Lines of Credit: Overdrafts, personal lines of credit, business lines of credit, credit cards, pay-later facilities, etc.
Secured
Under a secured loan/line of credit, you must keep your valuable assets, such as land, buildings, vehicles, etc., as collateral to the lender.
– Secured Loans: Mortgage loans, auto loans, home loans, etc.
– Secured Lines of Credit: Overdraft facilities on FDs (Fixed Deposits), FD-backed credit cards, etc.
Difference Between Loan and Line of Credit
Loans and lines of credit are both credit facilities offered by banks and other financial institutions to satisfy your financial needs. However, they differ in many ways, such as purpose, suitability, repayment method, etc. Let’s understand these differences in detail.
1. Purpose
– Loans: Generally taken for specific one-time expenses such as buying a car, home, home renovation, etc.
– Line of Credit: Used for ongoing expenses like shopping or any other short-term requirements.
2. Suitability
– Loans: Suitable for borrowers who want to borrow a fixed amount and repay in EMIs over a fixed period.
– Line of Credit: Ideal for borrowers who need funds on an as-needed basis.
3. Interest Rate
– Loans: Typically given at fixed interest rates and charged on the total loan amount.
– Line of Credit: May charge variable interest on the amount used.
4. Accrual of Interest
– Loans: Interest accrual starts once the loan amount is disbursed in your bank account.
– Line of Credit: Interest is only charged when you have used your credit limit and is calculated on the outstanding balance, not the total credit limit.
5. Nature of Borrowing
– Loans: Provide an upfront lump sum that you must repay over time in fixed monthly installments.
– Line of Credit: Offer a rolling credit line that can be used repeatedly. Your existing limit is increased or reinstated when you clear your dues.
6. Repayment Method
– Loans: Repaid in fixed monthly payments over the chosen loan tenure.
– Line of Credit: Requires you to clear the outstanding amount in one go after the bill is generated. You can also make a minimum payment per your bill, but you may have to bear higher interest rates.
7. Loan Limits
– Loans: Given based on your creditworthiness and income level; hence, there is a fixed limit.
– Line of Credit: Has a credit limit that can be increased or decreased based on your spending pattern and repayment.
8. Minimum Credit Score Required
– Loans: Typically, a credit score of 750 or higher is considered good, allowing you to get a loan easily at favorable terms. A lower credit score may result in higher interest rates.
– Line of Credit: May have lenient credit requirements compared to loans.
9. Tenure
– Loans: Have fixed repayment tenures starting from one year to several years.
– Line of Credit: Do not have a fixed repayment period.
Benefits of Loan and Line of Credit
Both loans and lines of credit come with their benefits based on your needs and financial situation. Here are some of the benefits of each:
Benefits of Loans
- Longer repayment periods allow you to repay the borrowed amount easily in fixed installments.
- Many loans are offered at fixed interest rates, ensuring your EMI remains the same throughout the loan tenure.
- Multiple types of loans are available for various purposes, such as buying a house, financing a car, funding for vacation or education expenses, etc.
- Timely and consistent loan repayment positively impacts your credit score, helping you build a healthy credit history.
Benefits of Line of Credit
- Provides a financial safety net for unexpected expenses, such as medical emergencies.
- Allows you to borrow money for shorter periods without the burden of long-term EMIs.
- Interest is charged only on the borrowed amount, not the total credit limit.
- Making on-time payments for your dues may make you eligible for a higher credit limit.
Loan vs. Line of Credit: Which One is Better?
The choice between a loan and a line of credit depends on individual financial needs and preferences.
– Loans: Suitable for making significant investments or expenses, such as buying a house, car, or home renovation. You get a lump sum from the bank in one go and can repay it in fixed installments.
– Line of Credit: Ideal for covering small, unexpected expenses, such as utility payments, rent payments, shopping, etc. You can use your line of credit to make these payments and repay your outstanding dues next month.
Conclusion
Both loans and lines of credit are credit facilities offered by banks or other financial institutions to meet your financial needs. Knowing the difference between both allows you to choose the better option for financing your various financial needs. A loan may be more suitable if you are going to make one-time expenses with a specific amount.
However, a line of credit may be the better option for ongoing or fluctuating expenses requiring flexibility in borrowing. Choosing the right financing option depends on your specific needs and financial situation. Evaluate your requirements carefully and make an informed decision to manage your finances effectively.
