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When it comes to paying for some of life’s big-ticket items — like a home renovation, a wedding or even a funeral — many people opt to use credit over cash. And credit can be especially useful when an expense sneaks up on you and you just don’t have enough in your emergency fund to cover the entire cost.
A personal loan and personal line of credit are both forms of credit you may consider turning to. And while they may sound like the same thing, they actually have some very important differences.
Read on for Select’s breakdown of what you need to know about the difference between a personal loan and a personal line of credit.
What is a personal loan?
A personal loan is a form of credit that’s given to you as a lump sum amount. You can use it to pay for just about any large purchase – home renovations, funeral expenses, medical bills or even unexpected emergencies if you don’t already have an emergency fund.
People also use personal loans as a form of debt consolidation. Basically, they apply for a personal loan for a specified amount of cash and then use the money to pay off one or more credit card balances that have higher interest rates than the personal loan they just took out. This can help you save on interest payments when you take out a personal loan with a low interest rate, like LightStream, which offers rates as low as 2.49%* if you pay using autopay.
Annual Percentage Rate (APR)
2.49% to 19.99%* when you sign up for autopay
Debt consolidation, home improvement, auto financing, medical expenses, wedding and others
Early payoff penalty
There isn’t really a hard-and-fast rule about what the loan must be used for, but you’ll usually have to explain the purpose of the loan when you apply for it. You might even consider using a personal loan to start a small business, but just make sure the lender doesn’t prohibit the use of funds for business purposes (you can read through their terms or ask the lender directly).
You’ll have to pay back the loan amount with interest in fixed, equal amounts each month for a prearranged amount of time (called the term of the loan). Because of this, it’s what’s known as installment credit. Personal loans usually carry a term of two to five years, but they can sometimes be repaid over the course of seven years.
Of course, there are many options out there, but you can make sure you’re getting a personal loan with the best interest rate by comparing different lenders. You can use this comparison tool from Even Financial to determine your top offers. The service is free, secure and won’t affect your credit score if you don’t apply for a loan.
Editorial note: The tool is provided and powered by Even Financial, a search and comparison engine that matches you with third-party lenders. Any information you provide is given directly to Even Financial. Select does not have access to any data you provide. Select may receive an affiliate commission from partner offers in the Even Financial tool. The commission does not influence the selection in order of offers.
What is a personal line of credit?
With a PLOC, you have a credit limit and you can spend up to that specified amount. But as you make monthly payments toward the balance that you have spent, your available credit is replenished. Essentially, you spend the money on an as-needed basis and you only pay interest on what you borrow. So because you can be approved for $50,000 but only spend $30,000, there is less pressure to use all the funds (unlike a personal loan, where it’s important to know exactly how much you’ll need to borrow).
There are two important phases of a PLOC you should know about: the draw period and the repayment period. During the draw period, you can borrow as much as you need but once the draw period is over and the repayment period begins, you can no longer borrow more credit. Paying back debt can often be tricky, but we’ve rounded up some tips that’ll help you kickstart a strong debt repayment plan.
How much do you pay in interest?
Personal loans carry fixed interest rates while personal lines of credit usually have variable rates over time — it’ll depend on the change in the prime rate set by the institution lending you money. But for the most part, a higher credit score can help you get lower interest rates.
According to the Federal Reserve, the current average APR for a two-year personal loan is 9.58%. ValuePenguin notes that although variable, the interest rate on a PLOC can range from 9.30% to 17.55%, but some lenders, like First Republic, can offer rates as low as 2.25%. By contrast, the average interest rate on a credit card is 16.30%, but can be as high as 24%.
However, some credit card issuers offer a 0% intro-APR period, which could save you money if you do a balance transfer to pay down debt or are expecting to make a large purchase. Just make sure you know how long the offer period lasts.
The Citi® Double Cash Card, for example, lets you make a balance transfer without paying interest for the first 18 months (after, 13.99% – 23.99% variable). Balance transfers must be completed within four months of account opening.
2% cash back: 1% on all eligible purchases and an additional 1% after you pay your credit card bill
0% for the first 18 months on balance transfers; N/A for purchases
13.99% – 23.99% variable on purchases and balance transfers
Balance transfer fee
Either $5 or 3% of the amount of each transfer, whichever is greater
Foreign transaction fee
Are there any fees?
A personal loan lender may charge an origination fee and/or an early pay-off fee (also known as a prepayment fee) if you pay off the loan before the end of its term. If you’re new to personal loans and want to save as much money as possible, you might consider one that doesn’t have an origination fee, like a Discover Personal Loan.
And while lenders don’t usually charge an early pay-off fee for personal lines of credit, they do have a few other fees of that come with this specific type of loan. An annual fee during the draw period can run you between $25 – $50. A late payment fee can be around 7.5% of the amount that was past due. And if your payment bounces back due to insufficient funds in your account or because of a closed or frozen account, you can also be charged a return payment fee of at least $25.
Regardless of whether a personal loan or personal line of credit is the better fit for you, always make sure you have a plan to pay them off. Generally, you should only try to take on debt you can afford to pay back, but if life happens and your ability to repay your debt is affected, speaking to a financial advisor for personalized advice can help you take control of the situation.
Also, make sure you’re comfortable with the interest rate and repayment timeline. Personal loans and personal lines of credit can be powerful tools to help you reach some of your financial and lifestyle goals quicker, but they should always be treated with careful planning.
*Your LightStream loan terms, including APR, may differ based on loan purpose, amount, term length, and your credit profile. Excellent credit is required to qualify for lowest rates. Rate is quoted with AutoPay discount. AutoPay discount is only available prior to loan funding. Rates without AutoPay are 0.50% points higher. Subject to credit approval. Conditions and limitations apply. Advertised rates and terms are subject to change without notice. Payment example: Monthly payments for a $10,000 loan at 3.99% APR with a term of three years would result in 36 monthly payments of $295.20.
Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.