A line of credit and a personal loan are both instruments of financing, but what is the difference between them? And how do they impact your credit score?
What is a Line of Credit?
According to Wikipedia, a line of credit is:
A credit facility extended by a bank or other financial institution to a government, business or individual customer that enables the customer to draw on the facility when the customer needs funds.
Or, from Investopedia:
A line of credit is a preset borrowing limit that can be used at any time. The borrower can take the money out as needed, until the limit is reached, and as money is repaid, it can be borrowed again.
In other words, a line of credit is money that the bank has approved which is sitting there waiting for you to use. The limit is set according to the bank’s determination of your credit-worthiness. If you don’t touch it, it stays in the bank.
There are three kinds of lines of credit:
- Personal: use according to your needs.
- Business: to start a new business or cover inventory and unexpected expenses.
- Home Equity: use to remodel your home or make major repairs. This line of credit is secured by your home.
It’s There When You Need It
Many consumers keep a line of credit open for emergencies. But you can also use it to make advance payments on wedding expenses or covering out-of-pocket medical expenses. Because most lines of credit are unsecured, you need a good credit score to be approved.
As you repay the line of credit, the balance is refreshed. You use and repay and use and repay. You pay interest only on the amount you have used, not on the total amount that has been approved. This is different from other kinds of financing such as personal loans where you pay interest on the total amount you have borrowed.
In most cases, the monthly payment is made by automatic withdrawal. This means you need to be sure you have the money in your account to make the payment.
What is a Personal Loan?
A personal loan is also a set amount of financing that you repay in installments every month. You might hear it referred to as an installment loan. The amount of your loan depends on your credit score, as does the interest and fees you will need to pay.
Usually, personal loans are unsecured, are for smaller amounts and have a payback period of a few years. You can use the money to cover wedding expenses, the costs of relocating, home improvement expenses, debt consolidation or uncovered medical expenses.
You can get a personal loan at the bank, credit union or online.
How Do Lines of Credit and Personal Loans Impact Your Credit Score?
As explained by FICO, your credit score is determined according to five factors:
- Payment history: 35%
- Credit utilization ratio: 30%
- Age of credit history: 15%
- New lines of credit: 10%
- Credit mix: 10%
Your credit utilization ratio is the second most important factor in determining your credit score. It is the percentage of total credit for which you have been approved vs. the total amount of credit that you have used. If your credit utilization ratio is higher than 30% your credit score will suffer.
You could have an excellent bill-paying history—always on time and never skip any payments—and still have a low credit score because you have used up too much of your available credit.
For example, your credit card has a limit of $10,000 and you have charged $5,000 on that card. Your credit utilization for that card is 50%. This doesn’t mean, though, that your credit utilization ratio for the purposes of determining your credit score is 50%. The ratio is based on the totality of your credit limit across all platforms: credit cards, loans, and lines of credit.
According to FICO, consumers with excellent credit keep their credit utilization ratio to 7%. This means, of the total amount of credit for which they have been approved, they have only used 7% of it.
There are two ways that a line of credit can impact your credit score.
- If you fail to make the minimum payment on your line of credit, your credit score will suffer as it would with any other type of financing. It’s very important to withdraw only the amount you need and can repay.
- You can use a line of credit to improve your credit utilization ratio. If you were to apply and be approved for a line of credit from your bank, the total amount of approved credit would increase. AND, if you don’t touch the line of credit, then you will succeed in bringing down your credit utilization ratio.
Impact of Personal Loan on Your Credit Score
A personal loan can also impact your credit score in either a positive or negative way. In most cases, your personal loan is repaid through automatic withdrawals from your bank account. This means that you never miss and are never late, both of which keep your credit score good. In fact, a personal loan can even improve your credit score. However, if getting a personal loan means that you bump up your credit utilization ratio, your credit score could fall. Needless to say, defaulting on the loan would also tank your credit score.
