Personal Loan vs. Line Of Credit: Which Is Right for You?

If you’re in need of financing, you might be exploring two of the most popular lending options: personal loans and lines of credit.

Both loan options can help you get access to money you need quickly, and both charge interest rates. Both can also help you build credit with responsible use. But they work quite differently, and each has its own set of benefits and drawbacks.

Here’s everything you need to know about choosing between a personal loan or line of credit.

What is a personal loan?

A personal loan lets you borrow a lump sum of money to finance a big purchase, pay down debt, or even fund a new business venture. Personal loans have fixed interest rates that are based on Canada’s prime rate.

The prime rate — the rate that banks, credit unions, and lenders use to set interest rates for consumer products — is currently 7.2% in Canada. This rate is directly influenced by Canada’s policy rate, which is set by the Bank of Canada and is currently at 5%.

Since personal loans have a fixed rate, you’ll have predictable monthly payments. Most personal loans in Canada offer financing between $100 and $50,000, and terms can range from six months to sixty months.

Every bank has its own credit score requirements for obtaining a personal loan. But to lock in a good interest rate, you’ll need good to excellent credit. There are some personal loans that cater to consumers with lower credit scores that can help you consolidate and pay down higher-interest debt. Sometimes, you can even get a loan with a “bad” credit score.

Personal loans have lower interest rates than credit cards but typically have higher rates than home equity loans. Many lenders charge origination fees and late fees, and some might levy early repayment fees. Your annual percentage rate (APR) comprises your interest rate and any other lender fees.

Are personal loans secured?

A personal loan is an unsecured loan, which means it is not backed by collateral and is therefore considered riskier to the lender. Since there’s no asset on the table to protect the lender’s funds, personal loans may have higher interest rates than secured loans and may have stricter credit requirements you must meet to qualify for one.

Current interest rates on personal loans

Right now, the current prime rate in Canada is 7.2%. Generally, the interest rates of secured loans start at a point above this (8.2%). However, unsecured loans, like personal loans, are typically a bit higher.

Depending on your credit score, you may find a personal loan with a rate as low as 9% or as high as 35% APR. The higher your credit score, the more likely you will qualify for a lower personal loan interest rate.

Pros and cons

Here’s what to consider when deciding if a personal loan is right for you:

Pros of a personal loan:

• Fixed interest rates

• Predictable payments

• One lump sum of cash

• Set repayment timeline

• No collateral needed

Cons of a personal loan:

• Less flexibility than a line of credit

• Higher interest rates than secured loans/LOCs

• Loan fees

• High credit score requirements

What is a line of credit?

A line of credit (LOC) offers you access to a credit limit that you can draw upon when you need money. Unlike personal loans, which offer a lump sum of cash, a line of credit is a revolving credit account. It’s akin to a credit card, which also provides a line of credit. However, lines of credit tend to have lower interest rates and different repayment periods than credit cards.

You can use a line of credit for various reasons — home improvements, education costs, financing a large purchase, business expenses, etc. There are different types of LOCs. The type of LOC you choose will have its own criteria for the types of purchases you can make, as well as your credit limit, repayment terms, interest rate, and credit requirements.

Most lines of credit have variable interest rates, which means they can increase and drop depending on economic conditions. That can make planning for monthly payments a little more unpredictable.

Once you have a line of credit, you can withdraw funds as you need them, and you’re typically only required to pay the interest on these purchases during your draw period. You can withdraw your money with a debit card, transfer it online to a bank account, or visit your bank or credit union in person.

The draw period

During your draw period, you can withdraw from your line of credit as many times as you’d like, as long as you don’t exceed your credit limit. This timeframe varies depending on the type of LOC you open. Some draw periods last up to ten years.

You don’t need to make monthly payments on your loan principal during this time, but you will need to make monthly payments on any accrued interest. You’ll only incur interest on the amount you withdraw—not the entire line of credit.

The repayment period

After your draw period’s over, it’s time to start paying back your line of credit. You’ll no longer be able to withdraw from your LOC, even if you have unused credit. You’ll start making monthly payments on your balance (plus interest).

How long your repayment period lasts depends on the terms of your loan agreement.

Secured vs. unsecured lines of credit

A line of credit can be secured or unsecured. Secured lines of credit generally offer lower interest rates, while unsecured LOCs have slightly higher rates.

A secured LOC is generally considered less risky to a lender — but it can be a riskier move for a borrower. Secured lines of credit require collateral to help protect the lender’s money. The most common type of secured line of credit is a home equity line of credit (HELOC). A HELOC requires you to put your home up as collateral, which is an important consideration to weigh. You could lose your house if you can’t keep up with your loan payments.

An unsecured line of credit adds more risk to the lender because it does not require collateral. Therefore, it often offers slightly higher interest rates and may have tighter credit requirements. Two common types of unsecured LOCs are a personal line of credit and a student line of credit.

Similar to a personal loan, a personal line of credit lets you borrow money for a big expense, but instead of receiving a lump sum of cash, you’ll draw upon the credit line as you need to. A student line of credit lets you pay for post-secondary and college expenses.

Current interest rates on lines of credit

Since most lines of credit have variable interest rates, the APR you’re charged will fluctuate based on the bank’s preference and the economy. The interest rate on your line of credit will depend on whether it’s secured or unsecured, the type of LOC, and your credit score.

Right now, HELOCs in Canada start at around 7.70% APR, but the rate can be higher depending on your credit score and financial details.

Personal lines of credit in Canada can start at around 8.20% APR but are generally over 9% to 10% APR.

Many student lines of credit in Canada start at 8.20% APR.

Pros and cons

Here are some benefits and drawbacks to consider before opening an LOC:

Pros of a line of credit

• Lower interest rates

• Ability to draw on a line of credit when needed

• Set draw and repayment periods

• Easy to qualify for

• Only pay interest on what you borrow

• Helpful if you need money for a project with unpredictable expenses, like a home repair

Cons of a line of credit:

• Variable interest rate

• Less predictability than a loan

• You risk losing your home (with a HELOC)

• It can be easier to overspend

Who is a personal loan best for?

If you know how much money you need to borrow, a personal loan can offer the security of fixed interest rates. This means you’ll always know how much you’re on the hook for paying each month. Your personal loan interest rate will remain unchanged if rates rise or fall.

A personal loan may make sense if you pay for something with a finite price or end date. Some examples include:

• A wedding

• Debt consolidation

• Financing a big purchase

• Paying student loan debt

This type of loan works best for someone who wants an upfront lump sum of money with no surprises.

Who is a line of credit best for?

Sometimes, you don’t know how much money you need to borrow — you just know you need access to capital to finance an expense. In those situations, a line of credit may make more sense. Although your interest rate could fluctuate, making your payments unpredictable, you can draw on a credit limit, using funds only if needed.

A line of credit may make sense to pay for:

• A home renovation or improvement

• Business or start-up costs

• Emergency expenses

• Projects that might have hidden or pop-up costs

This financing option will suit you better if you’re unsure of how much money you need or if you need money on different dates for varying expenses.

How to apply for a personal loan

If you decide a personal loan is a good fit for you, here are the next steps to take:

1. Research personal loan options. Before you apply, you should browse different lender offers. Look at APRs, repayment timeframes, loan amounts, credit score requirements, and fees.

2. See if you’re prequalified. Some lenders will let you prequalify for a personal loan. This requires inputting some financial and personal data to see if the lender is likely to approve you. If it does, there’s no guarantee you’ll be approved for the loan, but your chances are better.

3. Gather your financial documents. Make sure you have financial documents like bank statements, proof of income, and any other financial identification forms you’d like to include. You’ll need to have personal information handy, too, like your SIN.

4. Apply. When you’re ready, fill out the loan application online or in person at your bank to apply. The lender will let you know when to expect your funds if approved.

How to open a line of credit

Opening a line of credit is similar to applying for a personal loan. But there are some distinctions.

1. Research LOC options. First, figure out the type of LOC that makes sense for you. Then, be sure you meet the minimum requirements. For example, if you’re interested in a HELOC, make sure you have at least 20% equity in your home.

2. Compare lenders. Once you know what type of LOC you need, compare different lender offers. You may want to start with your bank — you could receive a rate discount for having more than one account. Compare APRs, line of credit amounts, credit score requirements, and fees.

3. See if you’re preapproved. You may be able to check out your changes of approval before officially applying. Apply for preapproval for your line of credit to see if the lender is likely to approve your application.

4. Gather the necessary documents. When you officially apply, you’ll need financial records like proof of income, bank statements, and mortgage payment records, depending on your LOC. Make sure you have these forms ready before applying.

5. Apply. All that’s left to do is apply. You can do this online, via mobile app, or in person at your bank. If you’re approved, you’ll receive the next steps for accessing your line of credit.

Does KOHO offer a line of credit?

KOHO is a credit-building company that can help you grow your credit score in various ways. It offers a revolving account with a line of credit that you can tap into when needed. Every time you make an on-time payment, KOHO will send your data to the credit bureaus, helping to boost your credit profile. You’ll also get free access to your credit score.

You can also open an interest-earning savings account with KOHO that offers up to 5% APY on qualifying purchases and comes with overdraft protection. Another unique feature is KOHO’s virtual credit cards, which allow you to shop securely online.

Learn more and apply at https://www.koho.ca/.