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Personal loan vs. line of credit: Which is better for you (and when)?

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Borrowing money can help you pay for a large purchase, cover an emergency, or consolidate debt. Many financial institutions offer two options for borrowing money: a personal loan or a line of credit.

While both can be smart borrowing options, how you access the money and pay off your balance depends on the type of loan you take out.

Let’s look at the differences and similarities between personal loans and lines of credit, learn how each works, and determine which product is right for you.

Personal loan: what it is and what it’s for

A personal loan or signature loan is a type of installment loan that pays out a lump sum of money. You receive the full amount you’re borrowing in one initial chunk, then repay it over time in fixed monthly installments.

Most of these loans are unsecured personal loans, which means you don’t need to provide collateral — an asset the lender would repossess if you fail to pay back the loan. However, some are secured loans, in which you fund a savings account or tie the loan to an asset to improve your chances of qualifying or to avoid a high interest rate.

In general, the interest rate of a personal loan is fixed, which means it remains constant throughout the loan term (though some banks offer adjustable-rate loans).

How to qualify for a personal loan

When you apply for a personal loan, you need to provide personal information such as your name, Social Security number, and proof of income. The financial institution then performs a credit check to determine if you meet their qualification requirements. During this process, the financial institution looks at your:

  • Credit score: A figure that tells lenders how well you manage debt. Most use the FICO credit score, which ranges from 300 to 850, and prefer borrowers with credit scores between 610 and 640 or higher. In general, borrowers with good to excellent credit (670 to 850) qualify for the most favorable interest rates.

  • Credit history: A record of your debt history. This tells lenders if you make payments on time, the type and mix of accounts (including loans and credit cards), and the amount of debt you carry such as student loans or credit card debt.

  • Debt-to-income ratio (DTI): A measure of how much debt you carry compared to your gross monthly income. This helps a loan provider determine if you can take on additional debt.

If you don’t qualify for a personal loan on your own, you may be able to apply with a co-borrower or co-signer. When you do, the co-borrower or co-signer’s credit is also taken into account in addition to your personal finances. If their credit is strong enough, the lender’s risk is reduced and the loan would be approved, though both parties — you and the co-borrower or co-signer — are responsible for paying back the loan.

Once your loan is approved, you must make monthly payments over the loan’s term — the number of months or years it takes to pay off the loan in full, including interest. A loan default or late or missed payments impact your credit history and drive down your score, making it more difficult to qualify for other credit and loans.

In many cases, you may pay off your personal loan early to save money on interest — something you should consider if your financial situation and creditworthiness change since you first took out the loan (for example, if you get promoted or get a higher-paying job). However, check your loan contract to see if you would be assessed a prepayment penalty.

When should you apply for a personal loan?

The best personal loans are ideal for covering one-off expenses, including:

In general, you should consider a personal loan when you need to borrow a set amount of money, like $4,000 for a vacation or $10,000 for a new roof.

Line of credit: what it is and what it’s for

A line of credit, or personal line of credit (PLOC), is a type of revolving credit, similar to a credit card. This means that it’s a flexible account that you draw from on an as-needed basis through a “draw period” — the period of time that funds are available to you. You only pay interest on the amount you borrow — not the total amount of available credit (though some lenders may require you to make a minimum payment each month). And, similar to a credit card, if you repay your PLOC during the draw period, you regain access to those funds.

For example, if you have a $10,000 line of credit and borrow $2,500, your available balance would be $7,500 — which you could continue to draw from at any time. While you would have to pay interest on the $2,500 you borrowed, if you paid it back within the draw period, you would be able to tap into the full $10,000 balance again.

A line of credit begins to accrue interest the moment you draw from the account. Most loan providers offer a variable interest rate based on the prime rate, so your interest payments may fluctuate. When the draw period expires, you can no longer borrow money from the PLOC and the repayment period begins. During the repayment period, you must repay the outstanding balance (including interest) in fixed monthly payments.

Personal lines of credit are, in general, unsecured by collateral, though they may be secured by assets like your car, home or a certificate of deposit (CD). Funds are often available via a card (similar to a credit card) or through a checking account, though they may also be deposited directly into your bank account.

Types of lines of credit

There are a few different types of credit lines, including:

  • Personal line of credit: A line of credit that is often unsecured. PLOCs are revolving accounts and function like credit cards. You pay interest only on the money you borrow. Funds may be used for whatever you want.

  • Business line of credit: A line of credit that is often unsecured and intended for business purchases. A business line of credit is similar to a PLOC, but approval depends on your business credit history and finances in addition to your personal credit. Some business lines of credit may be secured with company assets, such as equipment, inventory, or property.

  • Home equity line of credit (HELOC): A line of credit that is secured by the equity in your home. You can generally borrow up to 85 percent of your equity and use HELOC funds for anything you want, though they are often used for home maintenance, repairs, and renovations. Because a HELOC is secured by your home, it usually has a lower interest rate than unsecured lines of credit. Interest is often variable, though some lenders may let you convert a portion of your outstanding balance to a fixed rate.

  • Reserve line of credit: A line of credit that protects you from overdrafting your bank account. This type of credit line automatically covers transactions that exceed the funds in your bank account and works like other lines of credit, which means you pay interest only on the money you borrow. In addition, a reserve line of credit may work alongside other types of overdraft protection. Not all banks and credit unions offer this product, and some apply a monthly or annual fee to keep coverage in place.

How to qualify for a line of credit

Applying for a line of credit is the same as applying for a personal loan. Lenders require proof of identity and income and evaluate your credit score, credit history, and DTI in the same way. However, some lenders may be more strict about approving you for a line of credit vs. a personal loan and may require a higher credit score or better credit history.

If you don’t qualify for a credit line on your own, you may be able to apply with a co-borrower or co-signer to improve your odds.

When should you apply for a line of credit?

A line of credit is ideal for situations in which you need ongoing access to funds, such as:

  • Remodeling or renovating your home

  • Making up for lost/lower income

  • Protecting against overdrafts

  • Unexpected expenses

  • Projects with ongoing costs

For example, if you’re remodeling or renovating your home, a line of credit can provide consistent access to funds throughout the duration of the project, paying for labor and materials as needed. Or, if you’re struggling to make ends meet in between jobs, a line of credit can help you bridge the gap by providing a cushion of funds you can tap into until your income stabilizes and you’re in good standing.

Steps to decide which product to choose

Once you understand how a personal loan and a line of credit work, use these steps to determine which is best for you.

1. Consider why you want to borrow money

Before you start the loan application process, think about why you need to borrow money in the first place. Are you planning on making a single expensive purchase, or do you need funding to pay off a series of small expenses over time?

For example, buying a boat can cost thousands of dollars — but it’s a one-time expense. So you may be better off taking out a personal loan since you know the specific amount of money you need to borrow for a single purchase.

On the flip side, home renovations may add up over time. You may need a few hundred dollars while renovating your bathroom, a few thousand when you put in new kitchen cabinets and a few thousand more to install a new deck — but you don’t incur these costs all at once. In this case, a line of credit may serve you better than a personal loan.

2. Think about how often you need to borrow

A personal loan is one-and-done — after you get approved for it, you need to apply and qualify for a new loan if you need additional funds. With a line of credit, you have ongoing access to money when you need it. As you pay down your line of credit, you regain access to the available credit limit.

This means that if you expect to borrow money consistently, you’re better served by a line of credit. In contrast, a personal loan is often the better option if you only need to borrow funds once and don’t have an ongoing need for credit.

3. Account for your preferences

Whether you take out a personal loan or a line of credit, you will have to pay interest on top of the money you borrow. However, how you pay interest depends on the loan type you take out — which may impact your financial situation and budget.

How? Because personal loans are installment loans, interest is spread throughout the loan’s term. This means you’re responsible for paying fixed monthly installments — your monthly bill is consistent until the loan is paid off. This can make it easier for you to set aside the money and pay your loan on time.

In contrast, the interest due on a line of credit fluctuates during the draw period based on what you borrowed and the prime rate. This means you may need to pay a higher interest rate, in addition to a monthly payment that changes from month to month — which can complicate your personal finances. If you overextended and drew too much from your account, you may struggle to pay the interest in a given month.

4. Determine if you even need a loan

Both a personal loan and a line of credit are a type of debt. While debt isn’t always bad, taking it on without understanding the repercussions could make it difficult to qualify for other types of loans in the future — like a car loan or mortgage. Because loans impact your creditworthiness — even when all you’ve done is apply — it’s important to ask yourself if you really need one.

In some cases, an alternative option may be the better decision. For example, putting money into a savings account each month could help you pay for a major purchase outright or serve as an emergency fund if you get sick or lose your job. And if your credit history is poor or simply doesn’t exist, asking a friend or relative to add you to their credit card as an authorized user can help you establish a credit history — and secure a more favorable interest rate on a loan later.

In other words, remember that both a personal loan and a line of credit aren’t “free” money; they’re effective and helpful tools to finance large purchases, but they need to be used properly and in the right circumstances.