A loan and a line of credit are two different types of debt instruments. Both these products offer a certain type of borrowing facilities to borrowers.
Depending on the type and the borrower’s needs, a loan and a line of credit may offer different benefits and drawbacks.
Let us discuss what are the key differences and similarities between a loan and a line of credit.
What is a Loan?
A loan lending facility offered by a lender with a lump sum amount and certain terms and conditions for repayment.
It is a non-revolving form of debt financing. It means once the borrowed amount has been spent by the borrower, it cannot be reused.
A loan comes with an installment plan, interest rate, maturity period, and other loan requirements from the lender. Often, lenders require certain conditions from the borrower to obtain a loan.
A loan can offer a variable or fixed interest rate. Also, a loan can be secured or unsecured in nature. A secured loan requires collateral from the borrower.
Then, loans can be offered to individuals, small businesses, and large corporate borrowers. The type of loan and other terms depend on several factors including the type of borrower.
What is a Line of Credit?
A line of credit is a type of financing that comes with a revolving loan facility for the borrower. It is a type of loan that a borrower can reuse within a certain period.
Borrowers pay interest on the amount withdrawn from the account rather than the credit amount approved. This feature makes a line of credit a more flexible option than a loan.
A line of credit often comes with higher interest rates and can offer fixed or variable interest rates. These debt facilities are often approved for smaller dollar amounts and hence come with low monthly payments.
Types of Loan
Loans can be categorized in different ways like by interest type, by type of borrower, and so on.
Personal Loan
These are often unsecured loans granted to individuals. These loans can be used for any personal purpose like home improvement, education, and personal purchases.
Business Loan
These loans are granted to businesses and can be secured or unsecured loans. Business loans can come with variable or fixed interest rates.
These loans can be used for different types of business expenses.
Mortgage
These are secured loans offered to purchase a house or other types of property. A mortgage is backed by the property it is lent for.
Mortgages are often long-term loans and often offer low-interest rates.
Auto Loan
These loans are used to purchase used or new vehicles. These are also secured loans and the vehicle remains pledged with the lender until the full loan amount is repaid.
Student Loan
Student or education loans are often offered through federal lenders. They can be used for qualified educational expenses like paying for the tuition fees of a college program.
Refinancing/Consolidation Loans
Borrowers use these types of loans to refinance their existing loans or consolidate several loans into a single large loan.
These are often unsecured loans but the approval for these loans requires the high creditworthiness of the borrower.
Types of Line of Credit
A line of credit or revolving credit facility can also come in different forms.
Personal line of Credit
These revolving credit facilities are offered to individuals. These are mostly unsecured revolving facilities in the form of credit cards or account loans.
These facilities require low credit scores but charge higher interest rates.
Business Line of Credit
These are revolving credit facilities for businesses. This type of financing often comes with a variable interest rate.
A business line of credit can be secured or unsecured and the interest cost depends on the creditworthiness of the borrower as well as the borrowed amount.
Home Equity Line of Credit
These are secured revolving credit facilities offered to property owners. These facilities are backed by the market equity of the property like a house.
Lenders consider the remaining value of the mortgage and market value of the house before approving a home equity line of credit.
Loan Vs Line of Credit – Key Differences and Similarities
Let’s summarize some key differences and similarities between loans and lines of credit.
Structure
A loan comes with a predefined structure. It offers a lump sum amount once to the borrower.
It also comes with a predetermined loan maturity, monthly loan installments, interest rate, and qualification requirements. Once the borrower fully withdraws the loan amount, it cannot be reused.
On the other hand, a line of credit is a flexible financing facility. A credit limit is approved once and can be reused as many times by the borrower as required.
So, the monthly payment, interest charges, and other costs will depend on the amount utilized. Therefore, it is difficult to preset the structure of a line of credit as compared to a loan.
Interest Rate – Fixed and Variable
Loans and lines of credit can offer fixed and variable interest rates. The choice depends on different factors.
First of all, the type of loan or revolving facility being used will decide which type of interest rate is charged.
For example, a credit card comes with a fixed APR although it is a type of personal line of credit. On the other hand, an auto loan will often come with a fixed interest rate.
Repayment Terms – Installments and Maturity
A loan comes with a predetermined maturity date. Hence, the amount and number of monthly installments are also known at the time of issuing the facility.
Contrarily, a revolving facility only comes with the expiration date of the facility. It has no maturity date and hence monthly installments cannot be predetermined.
Unlike a loan, the monthly payment amount will fluctuate with a revolving facility. It will depend on the amount withdrawn and the previous balance.
Therefore, we can say that the borrower can control the monthly payable amount with a line of credit. However, the monthly payments are fixed for loans and must be paid irrespective of the utilization rate.
Secured and Unsecured Financing
A loan and a line of credit can be secured or unsecured credit facilities.
A secured loan is secured against an asset owned by the borrower. For example, a mortgage loan is secured against the property it is applied for.
Unsecured loans do not require a pledge from the borrower. However, they come with higher interest rates as compared to secured loans.
Similarly, a revolving facility can come with a variable or fixed interest rate. It also depends on the type of line of credit used by the borrower.
Individual and Business Lending
Loans and lines of credit are equally useful for individual and business borrowers. Lenders grant both types of financing facilities to businesses as well as individuals.
Credit cards, revolving loans, auto loans, and leases are common examples of financing facilities used by businesses.
Similarly, credit cards, home equity line of credit, mortgages, and personal loans are commonly used by individual borrowers.
Pros and Cons of Loans
Loans come with certain pros and cons as compared to lines of credit.
Pros:
- Loans come with a predetermined structure.
- Loans offer a set maturity date, monthly installment, and other conditions.
- Often require lower credit scores from the borrowers.
- Choice of fixed and variable interest rates.
Cons:
- Interest charges accrue as soon as the facility is approved.
- Borrowers need to pay interest rates even on the unutilized portion of the loan.
- Late payments incur more costs.
- The higher total cost of borrowing includes loan originating fees, processing fees, and closing costs.
Pros and Cons of Line of Credit
A line of credit has discrete pros and cons as well.
Pros:
- The flexibility of a revolving credit facility.
- Borrowers only pay interest on withdrawn amounts.
- Repayment options are flexible and borrowers can control the amount somewhat.
- The approved amount can be used for any purpose.
Cons:
- A line of credit is difficult to apply as lenders require excellent credit scores from the borrowers.
- These facilities often come with variable interest rates that can change adversely against the borrower.
- Lenders charge annual or facility-approval fees.
- An uncertain payment schedule also makes it difficult for the borrowers to forecast borrowing costs and plan accordingly.
