These are two major categories of debt you need to know about -- here are the big differences you need to understand.Image source: Getty Images.
When you need to borrow money without a specific purpose such as buying a house or car, you generally have two options. You can take out a personal loan, or you can choose to use a personal line of credit such as a credit card or home equity line of credit.
These are very different forms of debt, and it’s important to know all of the differences to determine which is best for you. With that in mind, here’s a rundown of what you need to know about personal loans and personal lines of credit, and how to figure out which makes the most sense for you.
Installment debts and personal loans
Personal loans are a type of installment debt, which has the defining characteristics of:
- A set loan amount -- When you take out an installment loan, you’re borrowing a specific amount of money.
- A set loan term -- Installment loans have defined lengths. For example, if you take out a 60-month auto loan, you’ll have repaid the obligation after you’ve made the 60th payment, and the loan will cease to exist. This is also known as a fully amortized loan.
- A set monthly payment -- Installment loans have set monthly payment amounts that are intended to completely pay off the balance by the end of the loan term. If an installment loan has a fixed interest rate, the monthly principal and interest payment will remain the same throughout the entire term. With a variable rate, the loan payment can change when the rate does.
A personal loan is a broad term that refers to installment debts that aren’t backed by a specific asset or made for a specific purpose. For example, mortgages and auto loans aren’t considered to be personal loans, as they are backed by the home or car the loan is used to purchase. Student loans aren’t considered personal loans, because they are made for a specific purpose.
On the other hand, personal loans aren’t backed by any specific asset, meaning that they are unsecured debts. If a borrower doesn’t make their personal loan payments, the lender cannot come and tow the borrower’s car away as an auto lender could. And they aren’t made for any specific purpose. A personal lender may ask the borrower what they intend to use the loan proceeds for, but once the loan has been made, a personal loan can be used for virtually whatever purpose the borrower wants.
Revolving debts and personal credit lines
The other main type of debt is revolving debt. Personal lines of credit belong in this category. The defining characteristics of revolving debts are:
- No set loan amount -- Instead, they have a credit limit, which is the maximum amount the consumer could borrow. For example, if you have a $10,000 credit line, you can choose to use all $10,000, nothing at all, or some amount in between.
- No fixed interest rate -- Most revolving debts charge interest that varies with a benchmark interest rate, such as the U.S. Prime Rate.
- No set loan term or end date -- In other words, when you obtain an installment loan, you know exactly when you’re going to pay off the debt obligation (assuming you make your payments on time). Credit lines are open-ended in terms of both repayment date and the existence of the credit line.
- No predetermined monthly payment amount -- Instead, they typically have a minimum payment that’s based on a certain percentage of the amount you owe.
Like a personal loan, a personal line of credit is a rather broad term used to describe various types of revolving debt available to consumers. Credit cards are the most common type of revolving debt, as they have a set credit limit and no defined end date to the obligation. Home equity lines of credit, or HELOCs, are another variety of personal credit line that allows homeowners to choose to borrow money against the equity in their home as they need it.
These also bring up another important distinction of secured versus unsecured debts. Personal loans are generally unsecured -- installment debts such as mortgages and auto loans that are backed by specific assets aren’t classified as personal loans. On the other hand, a personal line of credit can be secured or unsecured.
Here’s the difference. If you don’t pay your credit card debt, the lender can attempt to collect the debt, can sell your debt to a professional debt collector, or even sue you to recover the amount owed. It can report the delinquency or charged-off debt to the major credit bureaus and cause your credit score to plunge. However, your credit card issuer cannot foreclose on your home to collect its money. Your HELOC issuing bank can. This is why unsecured revolving debts represent a significantly higher risk to a lender, even if you have great credit, and is why credit card interest rates are often several times higher than the rates offered to HELOC borrowers.
Which type of debt is better?
Both types of credit accounts -- installment and revolving -- are reported to the three major credit bureaus and are reflected in your credit score. In certain ways, they are considered in the same manner, such as when it comes to payment history. In other words, a late loan payment can be just as bad as a late credit card payment.
On the other hand, the second-most important category in your FICO® Score is “amounts you owe,” and this is the big difference. This category makes up 30% of your score and mainly considers the amounts you owe relative to your original loan amounts or the amounts you owe as a percentage of your revolving credit lines.
In a nutshell, installment debts are considered more favorable than revolving debts, all other things being equal. For example, a personal loan with an outstanding balance of 80% of the original loan amount is better than a credit card with 80% of its credit line used.
To be clear, that doesn’t mean that personal loans are better forms of debt to use in all situations. For example, if you don’t need money now but want access to funds in emergency situations, a credit line probably makes more sense. Or, if you can pay off your debt relatively quickly, a credit card with a 0% intro APR may be a more cost-effective option that taking out a personal loan.
So while a personal loan is likely to be better for your credit, there’s no one-size-fits-all answer to the question of which type of debt is better.
Two very different forms of debt
The bottom line is that while personal loans and personal lines of credit may sound like similar concepts, the reality is that these are very different forms of consumer debt. In fact, the only real similarity is that neither type of borrowing has to be used for any specific purpose. While personal loans are likely to be better for your credit score and have some other key advantages, they aren’t always the best way to borrow money, so be sure to weigh all of the pros and cons before you decide.
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