Difference between a line of credit and a loan

Understanding the difference between a line of credit and a loan is a great first question to ask your financial team. A line of credit gives you access to funds up to a certain amount. You can borrow and repay these funds as often as you need. A loan is a lump sum of money for a purchase like a house, a car, or equipment. Repaying interest is different for both financial tools too. You will only pay interest on the funds you use from your line of credit, but you will pay interest on the entire sum of your loan.

Discuss time vs. money

When considering a line of credit, start by thinking of time vs. money. A line of credit should be used as a borrowing vehicle for a short period of time, such as a year or less. With a line of credit, you want to try to pay back the debt within a year because the interest rates are variable, meaning they will fluctuate with the market. If you need a longer payback period, talk to your financial advisor about different options such as a loan with a fixed interest rate.

In addition, consider how you want to use the money so you can make sure your assets are appropriately financed based on your goals. It is important to consider all the debt you carry, such as credit cards and loans, so you can determine how quickly you can pay back a line of credit and how it might impact your overall financial picture.

Different line of credit options

There are two main types of lines of credit that you can explore. The first is a home equity line of credit (HELOC), and the second is an assets under management line of credit.

A HELOC is a line of credit a lender provides you based on the value of your home, the amount of equity you have in it and your credit score. Most HELOCs have a variable interest rate. This means your rate, and, therefore, your minimum payment requirement, are subject to change, which can make it trickier to budget.

There are several different ways you can use a HELOC to renovate your home and make improvements to enjoy now or an investment in your home’s future. Either way, this line of credit option can be a tool to build additional equity in your real estate.

The second main line of credit is secured by your financial assets. For this lending option, the bank will determine how much equity you have in your stock and or bond portfolio and determine how much to lend to you. A line of credit secured by your financial asset can create liquidity against your stock portfolio that you don’t want to sell yet for tax reasons or because of you can get a stronger return if you leave the money in the market longer. There are additional things to explore with this option like capital gains tax, which could make your repayment expensive.

Why not just use a credit card?

You can use a credit card to pay for a large purchase but be mindful of the interest rate on your card and your credit limit. Ideally, you want to charge items to your credit card that you can pay off every single month to avoid paying high interest. A line of credit could have a lower interest rate than a credit card, making your repayments easier to fit in your budget.

You will also want to take into account your credit score before determining if a line of credit is the right option for you. Most lenders want to see a credit score above 600 before offering a line of credit. There are several different ways you can increase your credit score – if needed – such as paying bills on time, keeping credit card balances low and not opening any new credit cards.

A financial advisor can look at your finances and help you understand if a line of credit is the best vehicle to reach your next financial goal or discuss if another tool would be a strong option for you.

From paying for college to developing savings strategies, learn how to be more financially prepared in the years ahead by exploring the Plan and Invest playlist on the UMB Financial Education Center.