A line of credit and a credit card are both forms of a loan: You borrow money from a lender or credit card issuer and then repay the balance plus interest. However, both lines of credit and credit cards are not like the traditional loan that may come to mind, with fixed terms and monthly payments, such as an auto loan. Instead, both credit cards and lines of credit offer a far greater degree of flexibility with how you can use your funds and how you repay them. Though similar, lines of credit and credit cards do differ in some important ways. Read on to find out how lines of credit and credit cards work, how they’re similar and different and when it makes sense to get one or the other.
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How Does a Line of Credit Work?
It’s easier to understand what a line of credit is by comparing it to a standard loan. With a loan, you get one lump sum of money that you then pay back in installments, usually monthly. The monthly payments are comprised of the principal and accrued interest and they continue until you pay off the entire loan and interest, at which time the account is then closed.
With a line of credit, you’re given access to a set amount of money that you can borrow from as you need it, pay it back and then borrow again. You can access funds from your line of credit at any time as long as you do not exceed your credit limit, the maximum amount of credit extended to you is detailed in the agreement you signed when you first applied. The interest rate, size of payments and related terms are established by the lender. As with loans, a line of credit can be secured, meaning it requires collateral like a down payment, or unsecured, which may mean higher interest rates since no collateral is involved.
One of the principal advantages of a line of credit is the flexibility it offers. You can request a specific amount of credit, such as getting a line of credit with a limit of $10,000, but then only use part of it. You only owe interest on the amount you borrow from the line of credit, not on the entire $10,000 extended to you. As a borrower, you have more freedom in adjusting your repayment amounts based on your budget or cash flow. You can just make minimum monthly payments or pay down the entire outstanding balance in one payment. You also may be able to request credit line increases if your needs change.
How Does a Credit Card Work?
Credit cards are those familiar wallet-sized, plastic cards that allow you to make purchases using credit, which has been extended to you by the lender — the credit card issuer. When you get a credit card, you’re opening a credit account with the card issuer or lender. Thus, when you make a purchase with a credit card, you’re borrowing money from that credit account, which you then pay back with monthly principal and interest payments. The principal is the actual cost of the credit you borrowed while interest is a percentage of the cost of purchases charged by the lender as a fee for the privilege of borrowing money from them.
Credit cards come with credit limits, which is the maximum amount of credit a lender extends to a client. So, if you have a credit card with a credit limit of $5,000, you can tally up a maximum of $5,000 in purchases and interest before you can no longer draw any more money. Always remember interest’s part in your credit card balance. You may have made purchases that combined cost less than $5,000, but you reach your limit because the interest on your purchases has eaten up the rest of your available credit.
One of the defining features of credit cards is that there aren’t fixed terms on repaying the money you’ve borrowed. With a traditional term loan, like an auto loan or mortgage, you have a set number of years, number of payments and payment amounts all set out by the lender. With credit cards, your repayments are based on the amount of credit you’ve used for purchases, not on the size of the loan, which is how home loans, auto loans and lines of credit work. With credit cards, you’ll be expected to pay a minimum monthly balance to avoid late fees — or you can pay off a partial or full amount of your balance at any time. Additionally, when you pay off your entire credit card balance, it doesn’t mark the end of the loan and lead to an account closing. Your credit card account remains open after you pay it down to zero, you simply just have more credit available now and keep going through this process over and over again.
Line of Credit vs. Credit Card: Differences and Similarities
Both credit cards and lines of credit are forms of financing arrangements made between a lending institution and an individual or business. With a credit card, the lender provides access to funds that you, the borrower, can use at your discretion, essentially like an open-ended, flexible loan. Credit cards don’t have a time frame over which the loan amortizes.
With a line of credit, on the other hand, you enter into a one-time arrangement with the lender, and when you pay off your credit line, the account is closed. You can, of course, open additional lines of credit with the same lender, but these will be new accounts, whereas with credit cards, you keep paying and borrowing from the same account. Instead of swiping a credit card to access your funds, with a line of credit, you draw funds directly into your bank account.
Here’s a top-level breakdown of some of the key features of lines of credits and credit cards:
|Characteristics of a Line of credit vs. a Credit card|
|Feature||Line of credit||Credit card|
|Common uses||Personal: Large, special big-ticket consumer items or projects
Business: Business expenses and working capital
|Personal: Everyday consumer purchases with occasional big-ticket purchases
Business: Both everyday business purchases and specific business expenses
|Proof of income||Yes, typically in the form of a W-2 or tax return||No proof required, but you self-report income on applications|
|Secured or unsecured||Both secured and unsecured are offered||Both secured and unsecured are offered|
|Revolving or non-revolving credit||Both revolving and non-revolving lines of credit are available||Revolving credit|
|Credit reporting||Reported monthly to credit bureaus||Reported monthly to credit bureaus|
|Rewards||Very uncommon||Very common, including tiered rewards|
|Cash advance fee||None||Usually 3%-5%|
Both lines of credit and credit cards have two features make them particularly attractive: flexibility with purchases and flexibility with payments. Like a credit card, you can use a line of credit on an as-needed basis and pay off your balance or part of it when it makes sense for your budget. Another quality shared with credit cards is that there are personal lines of credit and business lines of credit just as there are personal and business credit cards. Business lines of credit typically have higher credit limits since it’s understood that business expenses are likely greater than personal spending.
Another shared trait is that both credit cards and lines of credit can be secured or unsecured. A secured line of credit or credit card requires you to put up collateral — usually a cash deposit — in order to get approved for credit. With an unsecured line of credit or credit card, there is no collateral, with your credit score being the chief basis for the lender extending you funds. Secured lines of credit and credit cards make sense for people with less-than-great credit or those building their credit profile. While you’ll have to put up collateral with secured credit, these lines of credit and credit cards typically have lower interest rates than their unsecured counterparts.
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Choosing a Line of Credit vs. Credit Card
Because of their similarities, it can be tough to determine when it makes more sense to get a line of credit and when it makes more sense to get a credit card. Really, it comes down to your circumstances and goals for how you’re going to use the funds.
One of the best and distinctive features of lines of credit is how cash advances work. While most credit cards allow cash advances, they are typically only up to a portion of your overall credit limit. On top of this, cash advances through credit cards can be expensive because of cash advance interest rates and cash advance fees charged. Lines of credit don’t typically have the same kind of limitations on cash advances. Usually, you aren’t restricted to only a fraction of your credit limit when you want a cash advance. This means you can use a line of credit to produce a large lump sum of cash quickly, which is ideal for addressing working capital and cash flow issues as well as emergencies. You also won’t face steep cash advance fees with a line of credit as you would with credit cards.
Credit cards are great for their convenience for making everyday purchases. The vast majority of places are equipped to accept credit cards at their point of sale. If you have a line of credit, it’s not always easy or common to be able to use it to make a purchase at a point of sale, making it less appealing for day-to-day purchases. You usually will have to move the funds from your line of credit to another account in order to make point-of-sale purchases. Also, credit cards often come with rewards programs, both for personal and business credit cards. This can be ideal if you make frequent personal or business purchases day-to-day because you’ll rack up either cash back or rewards points, which you can then save or put toward future expenses. Lines of credit only very rarely have similar rewards programs. In this case, you could be missing out on hundreds or even thousands of dollars in rewards if you opt for a line of credit over a credit.
The Bottom Line
Both lines of credit and credit cards can be valuable assets in your financial arsenal, when used responsibly, of course. These two forms of credit are quite similar with subtle differences. When choosing between getting a line of credit and getting a credit card, a helpful tip is to think about the kind of purchases you plan to make. If you plan to make everyday personal or business purchases, like gas, food, office supplies or utilities, a credit card might make more sense. If you plan to make a fairly large, big-ticket purchase, or intend to use the funds to cover business expenses and working capital, then a personal or business line of credit could be the best option.
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