Loans and lines of credit are two different methods of borrowing money. They are both available to individuals as well as business.
A loan is a one-time lump sum extension of credit. It is repaid through periodic, consistent instalments. A standard loan includes mortgages, student loans, auto loans and personal loans.
Lines of credit are extended to business concerns. The equivalent for individuals is the HELOC (Home Equity Lines of Credit). Neither of these are one time loans. A borrowing limit is established and loans can be taken again and again within the limit. Once the loans are repaid funds can be borrowed again on the same line of credit.
The differences between a standard loan and a line of credit are as follows:
PURPOSE: A standard loan is requested and approved for a specific purpose e.g. an auto loan, house loan, student loan. A line of credit is extended on the basis of the credit scores of the borrower. A specific purpose is not indicated.
TIME PERIOD: A standard loan has a definite start and end date. The borrower receives the loan on a specific date makes the purchase immediately. Sometimes the amount is paid directly to the vendor. E.g. a financial institution extending a student loan pays the amount directly to the educational institution.
Line of credit once started continues indefinitely, as long as loans are repaid and the borrowings remain within the specified limit.
SECURITIES: A borrower needs to put up some collateral before the loan is approved. These loans are secured against an asset. Lines of credit are extended on the basis of the credit scores of the borrower. No securities are required.
INITIAL PAYMENTS: Standard loans usually require a down payment or initial instalment. Line of credit does not have any such stipulation.
REPAYMENT OPTIONS: A standard loan offers the borrower various structured repayment options to choose from at the time of taking the loan. The schedule includes the time period for repayment as well as the monthly instalment to be paid. The interest is included in the monthly payment. The rate of interest is in direct proportion to the loan recovery time period. For example, a borrower will be given an option to repay the loan over five, seven or ten years. The rate of interest as per the schedule will correspondingly be 10, 11 or 12 %.
The standard loan lender pays out a large amount immediately, interest on a standard loan starts accruing immediately.
The repayment options for line of credit are much more flexible. Minimum monthly repayments are not mandatory, though the borrower is normally required to pay the interest every month. To offset the uncertainty of repayment, the interest rates are much higher than for a standard loan.
DURABILITY: A standard loan can only be used once and that too for a specified purchase purpose. Once the goods or services are purchased, no further purchases can be made. Only repayment remains.
Line of credit is a more flexible borrowing tool. The borrower starts making purchases as and when the need arises. The choice of goods or services purchased under a line of credit is exclusively the borrowers. No prior approval of the lender is required. Further line of credit is not a single use facility. The borrower can make multiple purchases within the specified borrowing limit.
IMPACT ON CONSUMER CREDIT REPORTS: Line of credit has a much greater impact on the consumer credit report. In order to build the credit score, some consumers take out a personal loan and use it to repay the line of credit. Finance savvy consumers thus use both forms of debt to their advantage.