When deciding whether to use a loan or a line or credit, it's important to keep in mind the way these financial tools work.
For a loan, you go to the bank or an online lending site, fill out the application, give proof of income and identity, then you're either approved or denied. The money comes in one lump sum deposited into your bank account.
A line of credit is a different animal. It's typically issued by banks, credit unions or lenders, but some retail stores may also offer them, strictly to buy their products or services, of course. Either way, a line of credit is an approval for funds up to a certain credit limit that you can then use as needed.
Loans are the right choice if you need a lump sum of money upfront. Some of the main uses of a line of credit are for trying to increase your spending power. Depending on the scenario, one may be a better fit than the other. In this article, you can find some of those situations and better understand when to use a line of credit or a loan.
Your Choice May be Limited by Your Credit History
Approval for a personal line of credit may require a higher credit score than approval for a loan. This can limit your choices today but, by applying for and paying off smaller personal loans, you can increase your credit score and make yourself eligible for credit lines later on.
A common practice, particularly with people just building their credit for the first time, is to deposit some money in a savings account and then take out a secured loan against those funds. Making all your payments on time shows the bank that you are creditworthy.
Credit cards are actually lines of credit, so applying for store cards with small spending limits can help you build credit. You could also take out a secured credit card, which can help build good credit history and increase approval chances on larger loans and credit lines.
A Line of Credit Doesn't Accrue Interest Until You Use It
Another benefit to using a line of credit is that you're not actually receiving any money upfront, so interest doesn't start accruing until you start using the funds you've been approved for. If you use them for variable expenses and pay them off monthly, you can keep the interest you pay to a minimum.
You may have already used a line of credit without realizing it. A common practice with local banks and credit unions is to reward their long-time customers with "overdraft protection." This is usually set up as a line of credit. Your account goes under, they dip into the credit line.
Minimum Payments will Land You Deeper in Debt
Whether it's a loan or a line of credit, try to borrow only what you can pay back in a short period of time. Interest accrues daily, so making only minimum payments on large loans or credit lines will land you deeper in debt. Try to pay more than the minimum each month.
If you need something today and it costs more than you can afford, consider taking out a loan. If you expect to need money in the future, a line of credit might make more sense. You don't have to spend any of it right now, and you can reuse it any time as long as you make your payments.
Notice: Information provided in this article is for informational purposes only. Consult your financial advisor about your financial circumstances.
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Original Source: When You Should Use a Line of Credit Instead of a Loan
