When the market is facing a downturn, it’s not uncommon for households to suffer a temporary setback in their financial stability, requiring them to adapt and make prudent adjustments to their budgeting and spending habits. In such instances, having instant access to credit can be no short of a blessing.
A line of credit and a loan are valuable tools for obtaining funds when required. Both credit types are something that the borrower can pay later to the lender.
For a layperson, who seldom engages with financial topics, it’s no surprise for them to be a stranger to the difference between a loan and a line of credit, so let’s begin from there.
What is a loan?
A loan or cash loan is a financial arrangement in which a borrower borrows some money from the lender, called the principal. This is done with the understanding that the borrower will repay the principal amount and interest over a predetermined period. Loans can be borrowed for different purposes. Thus, their principal varies based on their purpose.
What is a credit line?
Similar to loans, a credit line is a financial arrangement that allows an individual or business to access a predefined amount of funds, up to a specific amount, called the credit limit. The borrower has the freedom to withdraw any amount within the credit limit. Ultimately, the borrower has to repay the amount to the lender.
On what factors do the two differ?
- Flexibility: A loan provides the borrower with a lump sum upfront, while a credit line lets you borrow variable amounts within the credit limit.
- Repayment schedule: Loans generally have a fixed repayment schedule, over which the repayments should be made in installments. When a person borrows a quick loan, they know when and how much they need to pay the lender as outlined in their agreement. On the other hand, repayment for a line of credit depends on the borrower’s borrowing activity. The amount can vary each month.
- Interest rates: For loans, the interest is charged on the entire amount borrowed. On the contrary, interest is only charged over the amount withdrawn rather than the entire credit limit in the case of a credit line.
- Usage: As stated earlier, loans are designed to fulfill different purposes. Thus, the principal and repayment tenure varies based on the type of loan. Likewise, the usage of the principal is also limited to the purpose for which the amount is borrowed. For instance, a car loan would only be used to buy a car and nothing else. Credit lines are more suited for short-term purposes and function similarly to small personal loans that can be used to support regular expenses.
To conclude, a loan provides the borrower with a lump sum of money that they can use to fund significant expenses. The repayment term is fixed, and interest is charged over the total amount taken by the borrower. Like a loan, a credit line gives a borrower access to limited funds. Still, the interest is only calculated for the amount the borrower withdraws under the credit limit. Before taking any form of credit, discretion and personal assessment are necessary.
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