From credit cards to mortgages to home equity loans, there are many types of financing available these days. Most of these credit accounts fall into one of two categories: open-end lines of credit or traditional closed-end loans.
A line of credit lets you borrow money as needed and repay it when you want to replenish your available credit. Meanwhile, a traditional loan gives you a lump sum of money at once, which you must pay back in regular installments over a set period of time.
If you’re wondering if you should apply for closed-end credit vs. open-end credit, you’re in the right place. Below, we’ll discuss the differences between these two types of credit accounts and when you should use each one.
What is a Line of Credit?
A line of credit is an account that lets you borrow money as needed up to a set credit limit. There are typically no limitations on what you can purchase with this credit.
Once you borrow up to your credit limit, you’ll need to repay some of your outstanding balance before you can borrow more money again. You will also have to make minimum monthly payments to keep your account in good standing.
As long as your line of credit is active, you can borrow money from it and pay it back over and over again. For this reason, lines of credit are known as “revolving” credit accounts.
In other words, they’re sort of like reusable loans.
Types of Lines of Credit
Some popular types of lines of credit include:
- Credit cards
- Personal lines of credit
- Business lines of credit
- Home equity lines of credit (HELOCs)
Benefits of Lines of Credit
Since lines of credit don’t require you to reapply every time you need to borrow money, they offer a lot of financial flexibility. Plus, you’ll only be charged interest on the amount of money you borrow. If you don’t borrow any money, you won’t owe any interest. In contrast, if you take out a loan, you’ll pay interest on the entire amount, whether you end up using it all or not.
When to Use Lines of Credit
Due to these benefits, lines of credit are advantageous when you:
- Want the option to borrow money on an ongoing basis.
- Aren’t sure of how much money you need to borrow.
- Want a credit account you can rely on in emergencies.
For these reasons, you may want to take out a line of credit if you’re planning a home remodeling project or need cash flow support for your business.
What is a Traditional Loan?
When you take out a traditional loan, you receive all of your financing up front. If you need additional financing after you spend your loan money, you’ll need to apply for another loan from scratch.
Many types of loans can only be used for specific purposes. For instance, mortgages can only be used for home purchases, while auto loans can only be used to pay for vehicles. Other types of loans, such as personal loans, can be used for many types of expenses.
As soon as you receive your loan, you must start making monthly payments on it. (Though some lenders may offer promotions such as no payments for 90 days.) The number of months you’ll owe payments is based on your loan term.
Benefits of Traditional Loans
Compared to lines of credit, traditional loans offer the following benefits:
- Lower interest rates
- Larger borrowing limits
- Predictable monthly payments
- More lenient credit score requirements
Loans are also more likely to come with fixed interest rates than lines of credit.
When to Use a Traditional Loan
Traditional loans can help you pay for big, one-time expenses, such as a home, car, or expensive piece of business equipment. Since traditional loans often have lower interest rates than lines of credit, they may also be a better option if you know exactly how much you need to borrow for a personal expense. For example, you can use a personal loan to pay for a one-time home repair or medical bill.
Which is Better For Me: a Line of Credit or a Traditional Loan?
The right form of financing will depend on your unique situation. If you need flexible, ongoing financial support, a line of credit may be the best option. If you need help paying for a large, one-time expense, a traditional loan may be better instead.
In some cases, you may benefit from having both types of credit accounts. Gaining experience with both types of accounts can help you optimize your credit mix, which is an important factor used in your credit score’s calculation. However, it’s also important to never borrow more than you can afford to pay back. That’s why it’s also important to establish an emergency fund.
