Differences between a loan and a line of credit
Lines of credit and loans are two different financial products that allow users to borrow money. However, they have differences which should be taken into account when choosing one or the other.
A line of credit is typically offered by a financial institution as a reusable amount of funds that a borrower can incrementally pull from on an as-needed basis. Although a credit limit is established when a borrower is approved for a line of credit, the available funds are not given in a cash lump sum. Instead, borrowers progressively withdraw money, up to their credit limit, to cover purchases, using an account number or a credit card. In most cases, borrowers have an allotted time to pay back the total amount of a purchase before it possibly accrues interest. As a borrower repays the used credit, funds will be recycled and made available for future use.
On the other hand, with a loan, a lender — usually a financial institution —transfers a fixed, lump sum of money at the beginning of a transaction to a borrower. The borrower undertakes to repay that amount, plus the agreed interest, in one or more installments over a set period of time.
The basic differences between loans and lines of credit are the following:
- With loans, the total amount of funds is transferred to the borrower at the beginning of the loan term, but with lines of credit, the borrower withdraws funds to cover specific needs as they arise.
- Loans come with interest that must be paid from the moment the principal amount of funds is transferred, while, in lines of credit, interest is only paid on the portion of available funds borrowed.
- While a line of credit can be renewed several times upon maturity, loans have to be repaid in full within the agreed term.
- Lines of credit are subject to shorter maturity terms than loans, but are often subject to higher interest rates than loans.
- Line of credits are typically taken out by part- and full-time workers to cover personal needs in between paychecks, and by self-employed professionals and small- and medium-sized enterprises to cover their working capital needs at specific times.
- Loans are normally taken out to purchase high-value assets (such as vehicles), finance long-term capital needs or fund a sizeable investment (such as a house).
- Some loans require a reason or purpose for requesting funds, oppose to a lines of credit that typically do not require a lender’s approval to make purchases.
In either case, potential borrowers should carefully evaluate their funding needs in terms of volume and time, taking into account that there are several loan options available depending on the specific need.
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