What Makes a Line of Credit Different from a Loan?

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Category: Loans
Posted on: 10/27/2020
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When you need extra money, you have options. Two important ones are a loan and a line of credit. Both can provide you cash, and both have to be repaid. But when you get into the details, you see that they differ in several important ways, including how you access the money, how you repay it, and how long it is available.

Definitions

loan is a lump sum of cash you borrow from a family member, friend, bank, credit union, or some other source. We'll ignore loans from family and friends because there are no regulated rules for them. Some loans are secured by collateral, such as a home or vehicle, while others require nothing more than your signature. Loans are to be repaid by a fixed date, either in installments or all at once. Typical loan types include auto loans, mortgages, student loans, and personal loans.

line of credit also allows you to borrow money. However, it is a revolving account, meaning you can repeatedly borrow, repay, and reborrow from the same credit line. You can borrow up to the line maximum, and you must repay at least the minimum amount due each month. A line of credit may be secured or unsecured (most are secured) and may have a date upon which it terminates. One of the most popular varieties is a home equity line of credit (HELOC), which is secured by the equity you have in your home. Your equity is the difference between the home's value and the balance on your mortgage.

Banks, credit unions, and other institutions are the typical providers of credit lines.

Initiation

Whether you are applying for a loan or a line of credit, lenders will want to evaluate your creditworthiness based upon your credit history and your current financial status. Past problems like collections and bankruptcies may disqualify you from borrowing on an unsecured basis.

The process is more straightforward if your loan is secured by property, in which case the lender must ascertain the property's value. In secured lending, the amount available to you is usually less than or equal to the collateral's property value. 

Upon approval, the proceeds of a loan are forwarded to you. This can be cash, check, or via direct deposit to your checking account. When you are approved for a credit line, you receive a new account, a debit card, and checks that you can use to borrow exactly the amount you need, when you need it, up to the credit limit. 

Interest

Interest is the expense you pay for borrowing money. Lenders collect interest based on the amount you borrow. The interest rate may be fixed or variable. The interest rate depends on the amount you borrow, your creditworthiness, the loan term, and the prevailing interest rates for similar loans. 

Loans may be amortized, or they may charge all the interest first. With an amortized loan, you make a fixed payment each month. During the early part of the term, most of the payment is allocated to paying interest. As the term matures, more of the payment goes to repay the principal. The last payment is almost entirely principal. Loans and revolving lines of credit are usually amortized, whether secured or unsecured. 

An interest-only loan is unamortized. It is often used on secured loans to postpone repayment of principal to a later date.

APR is the annual percentage rate you'll pay, including interest and any fees you pay over the loan course. The total interest you'll be charged for a fixed-term loan is based on the initial loan amount. Since it is known upfront, it is used to prepare the amortization schedule, which in turn determines your monthly payment amount.

The amount of interest you'll pay for a line of credit is a function of your daily unpaid balance. It works like this: The lender divides your APR by 365 to get your daily interest rate. That rate is applied every day to your unpaid balance. Therefore, on days when you own nothing, you are charged no interest. Lines of credit are often compared to credit cards, which is another type of revolving credit account. However, when you charge purchases on your credit card and then pay the full balance on the next payment date, you will be charged no interest. That period of free credit is called the grace period. Charges to your credit line are more like credit card cash advances because both charge you interest from the first day — there are no grace periods.

Payments

Loan payments are usually due in installments on the same date each month for the loan term. You can repay by sending in a check, but the amount is often debited from your bank account. If you are late paying your bill, you can be charged a late fee. Some loans let you roll over late fees into principal, but this can send you into a debt spiral that might lead to bankruptcy. 

With a line of credit, your payments reduce the amount you owe and pay any interest you've accrued. You can borrow the difference between your loan balance and your credit limit. Interestingly, you can make a monthly payment and then immediately reborrow the same amount. This will increase the principal you owe because only part of your last payment was applied to the principal — the rest was interest. Unless you pay down the principal, your balance will increase until you reach your credit limit.

Nonetheless, lines of credit are extremely flexible, allowing you to borrow money when you need it without having to apply for another loan. This convenience comes at a price — credit lines typically have higher interest rates than comparable installment loans.

Borrowing should be convenient. Loans can be helpful but are less convenient than lines of credit. However, an installment loan from a bank, credit union, or online marketplace may be less expensive than a line of credit. The higher interest on a line of credit buys you the flexibility to borrow and repay according to your current circumstances. Armed with this information, you should feel more confident in deciding which option is right for you. Click here to see what's available to you with Finance Guru!

 

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