The Difference Between a “Loan” and a “Line of Credit"

Many of us ask the question, what is a line of credit? It seems most do not have a full understanding of the term. A line of credit is often confused with other forms of borrowing such as conventional loans. This article will define the term "line of credit" and how it differs from a regular loan.

A loan is money borrowed for a specific purpose, at a certain interest rate, and for a certain period of time. The loan also normally requires a fixed monthly payment at a specified date during the month. Car loans and mortgages are examples of typical “loans”. In addition, all loans are negotiable with the credit facility you have chosen to do business with. You can negotiate the amount of the loan, length of time to payback, and the interest rate.

In most cases the shorter the loan period the less interest will be paid over the life of the loan. Your monthly payment will be divided into two portions – one part is applied to the loan principle and the second is applied to the interest. In the early stages of the loan, a greater portion of the monthly payment will be applied to the interest. As the loan matures, a gradual greater proportion of the total payment will be applied to the principal until the loan is paid in full. Loans can take the form of secured and unsecured. Typically, loans are secured by the item purchased with the loan proceeds. However, unsecured types of loans are common.

The definition of a “line of credit” is a specified dollar amount or “limit” issued by a lender to a borrower. The borrower then takes advances against this specified “limit”. The advances can be taken during a defined period of time, and in some cases the payments are at the borrowers’ discretion. However, full payment must be made at the end of the defined period or “maturity date”. However, monthly payments are normally required until the end of the defined period, at which time full payment is required.

As such, a line of credit can be defined as a loan – except you do not have to take full custody of all of the funds at the beginning. You withdraw funds only as you need them. The main advantage of a line of credit over a loan is that you do not have to pay interest on the full amount of your “limit”. You just pay interest on the total amount advanced to you – or the amount of the line you are currently using. In addition, the main advantage a line of credit has over a credit card is that you normally do not have to pay transaction fees and cash advance fees as you would when you take a cash advance from a credit card.

Moreover, many line of credit limits are issued based on an amount that you can borrow against using some type of collateral. This would be described as a “secured line of credit”. In this case, your line of credit limit would be determined by the “net value” of an asset you own – like a home. If you had full ownership of the asset, your line limit could be as high as the total value of the asset. Just like a conventional loan, many lines of credit do not require collateral and are issued unsecured. In this case, the “limit” would be determined by the amount of your other financial obligations, your ability to repay, and your credit history among other factors.

In conclusion, lines of credit are a very flexible and negotiable form of borrowing. Whether secured of unsecured, you have more options in terms of how and when you use the funds and how and when you repay the funds. With conventional loans, you must adhere to a stricter set of loan requirements. However, a conventional loan may be easier to qualify for since you must declare how and when you will use the borrowed funds.

There are many strategies and techniques for negotiating and obtaining various forms of credit from lenders.  Understanding the advantages and disadvantages of the many loan products in the marketplace can assist you in making better decisions as a borrower. (Press Ctrl-D to bookmark this page for future reference)