Personal loans and lines of credit are versatile borrowing options that can help individuals manage financial needs, from consolidating debt to making large purchases or covering unexpected expenses. Unlike secured loans, these borrowing methods are usually unsecured, meaning they do not require collateral. While personal loans provide a fixed amount with set repayment terms, lines of credit offer flexible access to funds as needed. Each option comes with advantages, such as lower interest rates than credit cards and a more straightforward application process, but it also has tradeoffs, including higher interest rates than secured loans and potential risks associated with lender offset rights. Understanding how these borrowing tools work can help individuals make informed decisions about when and how to use them effectively.
What is it?
When you take out a personal loan, you borrow an amount of money for a certain period of time and pay interest on the outstanding principal balance. Generally, a personal loan is unsecured. There is no collateral. Personal loans are often acquired to make a specific purchase or to consolidate other high interest loans into one monthly payment. Most personal loans are obtained from a bank, credit union, or savings and loan. However, a loan from a family member or other private lender is often referred to as a personal loan.
A personal line of credit is a common alternative to a personal loan. When you apply for a line of credit, the lender establishes a maximum amount that you may borrow. That is called your credit limit. You may borrow what you need, as you need it, in any amount, as long as your outstanding principal balance does not exceed your credit limit. If you reach your borrowing limit, you can pay down the balance and then borrow more. Personal lines of credit are usually unsecured. Typically, there is no fixed repayment period as long as you make the minimum monthly payments. Interest rates are typically lower than credit card rates. If your line of credit is with a financial institution, you likely access it with a check, a debit card, or a withdrawal slip.
Who can obtain personal loans or credit lines?
Depending upon the amount you wish to borrow, anyone with a steady income can apply for and obtain a personal loan or line of credit. You must demonstrate to the lender that you have the ability to make regular monthly payments on the debt. Most banking institutions will set you up with a line of credit attached to your checking account, often called an overdraft line of credit. The line of credit allows you to write checks for more than your checking account balance, although any amount in excess of your checking account balance must be repaid with interest. Most banking institutions also offer personal loans to their established customers. As with most loans, personal loans and credit lines are easier to obtain if you have established credit.
What are the advantages of personal loans and lines of credit?
Generally, interest rates are lower than credit cards
Most banking institutions offer lower interest rates for personal loans and lines of credit than they do for credit cards. Interest rates tend to be about 2 percent lower than credit cards. This makes borrowing money cheaper. However, as with auto loans, interest rates can vary greatly from lender to lender. If you want to obtain a personal loan or line of credit, call no less than six institutional lenders to get an idea about the going rate.
No collateral required
Personal loans and lines of credit are typically unsecured. That means there is no collateral backing the loan. The lender has nothing to repossess if you fail to make payments on the loan.
Application process is fairly simple
Typically, the lender will approve your personal loan or line of credit on the strength of your credit report. There is no collateral and no down payment. Accordingly, the application is usually short and easy to complete.
What are the disadvantages of personal loans and lines of credit?
Interest rates are higher than most secured loans
The interest rate on a personal loan or credit line is typically higher than the interest rate for a secured purchase money loan. A purchase money loan, such as an auto or boat loan, is secured by the merchandise you buy. Typically, interest rates are lower because the lender has collateral backing its loan, which makes the loan less risky. If you are considering a personal loan to finance a car, boat, or other major purchase, you will likely get better interest rates with a secured purchase money loan.
Lenders have offset rights
If you obtain a personal loan or line of credit from a bank, credit union, or other financial institution where you also have a checking or savings account, the money in these accounts may become vulnerable. In certain circumstances, financial institutions have offset rights. This means that if you default on your personal loan or line of credit, the lender has a right to take money out of your checking or savings account to satisfy the debt. The financial institution can do this without your permission. The old rule of thumb is: Never borrow where you save.
When would you choose a personal loan over a line of credit?
Use a personal loan if you are planning to make a large purchase, such as furniture or a major appliance, and you know you cannot pay off the entire balance in one month. Personal loans have a fixed term. If you make the regular payment each month, you will retire the debt within the term of the loan. Lines of credit, like credit cards, have no set repayment terms. If you can be tempted into making only the minimum required monthly payment each month, you will be making payments for a long period of time and paying a great deal of interest.
Lines of credit should be used like credit cards. Use them for unexpected expenses. Use them because they are convenient. Pay off the balance each month to avoid interest charges. Keep a credit line open for emergency expenses.
What are the tax implications of personal loans and credit lines?
Interest on personal loans and credit lines is not deductible.
Conclusion
Personal loans and lines of credit provide accessible and flexible borrowing options for individuals who need funds for purchases, debt consolidation, or emergency expenses. While they offer benefits such as lower interest rates than credit cards and no collateral requirements, borrowers should be mindful of higher interest rates compared to secured loans and the potential risk of lender offset rights. Understanding when to use a personal loan versus a line of credit can help borrowers manage their finances more effectively. By making informed decisions, comparing lenders, and using these financial tools responsibly, individuals can take advantage of personal loans and credit lines while minimizing risks and unnecessary costs.
Scarlet Oak Financial Services can be reached at 800.871.1219 or contact us here. Click here to sign up for our weekly newsletter with the latest economic news.
Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
