Both loans and lines of credit let consumers and businesses to borrow money to pay for purchases or expenses. Common examples of loans and lines of credit are mortgages, credit cards, home equity lines of credit and auto loans. The main difference between a loan and a line of credit is how you get the money and how and what you repay. A loan is a lump sum of money that is repaid over a fixed term, whereas a line of credit is a revolving account that let borrowers draw, repay and redraw from available funds.
What is a Loan?
When people refer to a loan, they typically mean an installment loan. When you take out an installment loan, the lender will give you a lump sum of money that you must repay with interest in regular payments over a period of time. Many loans are amortized, which means that each payment will be the same amount. For example, let’s say you take out a $10,000 loan with a 5% interest rate that you will repay over three years. If the loan is amortized, you will repay $299.71 each month until the loan is repaid after three years.
Most people will take out some type of loan throughout their lifetime. Generally speaking, people will take out loans to purchase or pay for something they couldn’t otherwise pay for outright -- like a house or car. Common types of loans that you may encounter include mortgages, auto loans, student loans, personal loans and small business loans.
What is a Line of Credit?
A line of credit is a revolving account that lets borrowers draw and spend money up to a certain limit, repay this money (usually with interest) and then spend it again. The most common example of this is a credit card, but other types of lines of credit, such as home equity lines of credit (HELOC) and business lines of credit, exist.
Let’s walk through an example of how a credit card works. When you get a credit card, the bank or credit card issuer sets a maximum credit limit that you can borrow, and you will be responsible for repaying what you spent each month. For instance, the bank may offer you a $5,000 credit limit. If you spend $2,000 one month, that means you can only spend an additional $3,000 before you reach your credit limit. Once you repay the $2,000 you spent, you can then spend up to $5,000 again. Credit cards are a bit unique in that if you pay your balance in full every month you won’t have to pay interest on the charges. Other lines of credit will charge interest each time you draw from them.
Some lines of credit are also open-ended meaning that the line doesn’t close after a certain period of time like an installment loan. Others may allow you to draw money for a certain number of months or years before the line closes and you have to repay. In most cases, you will need to pay a minimum amount each month to avoid additional fees or penalties.
Loan vs. Line of Credit
In general, loans are better for large, one-time investments or purchases. This could be the purchase of a new home or car or paying for a college education. Lines of credit, on the other hand, are better for ongoing, small or unanticipated expenses or to even out income and cash flow. For instance, a small business owner might use a credit card to pay for office supplies and materials every month. A homeowner might take out a home equity line of credit to pay for ongoing remodeling costs when she isn’t sure how much the project will cost.
Loans usually have fixed interest rates. This means that if you take out a loan with a 5% interest rate, that rate will not change during the life of the loan. On the other hand, many lines of credit have variable rates, which are normally based on the Wall Street Journal Prime Rate plus some margin. For instance, a bank might quote the rate on a HELOC as the Prime Rate plus 2%. If the Prime Rate is 4%, the interest rate would be 6%. As the Prime Rate changes, so will the interest rate on the line of credit.
Personal Loan vs. Line of Credit
In general, personal loans come with fixed rates and terms, whereas as personal lines of credit are usually open-ended with variable rates.
|Typical Terms||Personal Loan||Personal Line of Credit|
|Loan Amount||Up to $50,000||Up to $25,000 to $50,000|
|APRs||5% - 36%||8% - 24%|
|Loan Terms||Up to 5 years||Open-ended|
|Repayment||Fixed monthly payment||Minimum monthly payment|
|Major Fees||One-time origination fee: 1% - 6%||Ongoing annual fee: $25 - $50|
Home Equity Loan vs. Line of Credit
Currently, home equity loans and lines of credit have similar interest rates, but as the Prime Rate changes, the interest rates on HELOCs will change.
|Typical Terms||Home Equity Loan||Home Equity Line of Credit (HELOC)|
|Loan Amount||Based on equity in home||Based on equity in home|
|APRs||3.2% - 7.5%||3.5% - 6.7%|
|Loan Terms||5 to 30 years||10 year draw period followed repayment period|
|Repayment||Fixed monthly payments|
Small Business Loan vs. Line of Credit
Small business loans and lines of credit come in a variety of types, with banks and online lenders offer vastly different products.
|Typical Terms||Small Business Loan||Small Business Line of Credit|
|Loan Amounts||Up to $5 million||Up to $1 million|
|Interest Rates||Fixed||Fixed or Variable|
|APRs||5% - 30%||5% - 40%|
|Loan Terms||1 to 20 years|
|Repayment||Fixed monthly or weekly payments||Minimum or fixed monthly or weekly payment|