Line of Credit vs. Loan

If you are in need of cash, is it better to obtain a line of credit or a loan? This will very much depend on two factors - what you actually plan to use the money for and how disciplined you are around money. A line of credit will work in the same way as a credit card, therefore you will be issued with a credit limit and you are only required to make interest payments on a monthly basis. In order to repay the capital, you can either make additional payments during the line of credit term or simply pay it off at maturity. A line of credit will also typically be issued with a variable interest rate.

A loan will generally involve you have to make fixed payments over a specific period of time. You will be charged interest on the full amount of the loan from the day you take it out, and most loans are issued with a fixed interest rate. This means you will be aware of exactly what your monthly payments are, and therefore it is easier to budget for these payments.

Your loan will work in much the same as a mortgage, and therefore you can expect to make monthly payments for 10-30 years. As mentioned, loans are typically offered at a fixed rate, although these can often be higher that the rates offered with a line of credit.

A line of credit will offer a borrower far more flexibility, as they can simply withdraw money as and when they need to. This is a great way to pay for purchases that require ad hoc payments. A prime example of this would be a construction company is remodeling your home. They will generally require payment as each stage is completed. However, in this scenario if you have taken out a loan to pay for the construction work, you must remember that you will be charged interest from the day your loan starts, even though your first payment to the construction company may not be due for a few weeks or months.

With that said, I mentioned that earlier that one of the factors to which type of borrowing is best for you will come down to self discipline. A line of credit is a great way to have access to money as and when you need it, and you are only required to pay for the interest charged on a monthly basis. However, if you aren't particular good at controlling your spending habits, a line of credit may see you spending money on various things that you don't really need, and therefore running up unwanted bills.

If you repay the entire balance, the full line of credit will once again be available to you, just like a credit card. This could, unfortunately, see you caught in a vicious circle of constantly having an outstanding balance on your line of credit. Worse still, if you choose to simply make the minimum interest payments on your line of credit, you will need to repay the entire balance once it has matured. If you don't have any spare funds to do this with, you may be forced into an expensive refinance deal or even having to sell your home.

If you are unsure whether a line of credit or loan is the best option for you, there are 5 questions you should ask yourself first:

1) Would you prefer to have the money in one lump sum or as several installments?
If you need the money in a lump sum then opt for a loan, and if several installments makes life easier go with the line of credit.

2) Do you need the money for short-term or long-term purposes?
If the money is going to pay for something that is likely to last for a long time, such as a car or a new roof on your house, then a loan is the best option. However, if the money is going to be spent on something for the short-term, such as a wedding or a semester at college, opt for the line of credit.

3) How much of a monthly payment can you afford?
If you take out a loan you will need to pay both principal and interest on a monthly basis for the entire term of the loan, but a line of credit will only require you to pay the interest every month.

4) If you had money available to you in a line of credit, would you be tempted to use it carelessly?
Once again, this is down to your own self discipline. If you believe that it will be difficult to control your spending with a line of credit, you should always opt for a loan.

5) Would a variable interest rate bother you?
Many people prefer loans with a fixed rate, as it allows them to budget their finances on a monthly basis. If this is something that is important to you, then you should go with a loan, however, if repaying this money isn't really a concern, you may be better off with a variable rate line of credit that should initially cost less than the fixed rate offered on a loan. With this option you will need to be wary of when the Federal Reserve increases or decreases the federal fund rates.