Two of the most common methods of borrowing money are credit cards and lines of credit. Both credit cards and lines of credit are forms of revolving credit, a type of loan that allows the borrower to spend up to a predetermined limit, repay the balance and then borrow up to that limit again.
The similarities largely end there, though. Interest rates, access to funds and repayment all tend to differ between these two products.
[Read: Best Credit Cards for Good Credit.]
What Is a Line of Credit?
A line of credit is a loan that allows you to borrow money up to a certain limit. Unlike a traditional loan, you don’t receive the money as a one-time lump sum. Instead, you borrow funds as needed and only pay interest on the money you’re spending. Lines of credit can be secured (backed by collateral like your home) or unsecured. Secured versions typically offer lower interest rates.
For example, you might get approved for a $20,000 line of credit. You could use that line of credit to make a $5,000 purchase, which you would need to pay interest on. The remaining $15,000 of your credit limit would not accrue interest charges until you actually borrowed against it. When you pay back the principal on the amount you’ve used, your limit goes back up to the original amount.
What Is a Credit Card?
Credit cards are physical payment cards designed for everyday use, but they function similarly to lines of credit. When you apply, you’re approved for a certain credit limit. As with a line of credit, you only rack up interest on the portion of your credit limit you’re actually borrowing, and your available credit replenishes as you pay back your purchases. Credit cards can be secured or unsecured — though secured cards are typically secured with a cash deposit of a few hundred dollars, rather than your home.
[READ: Best Credit Cards for Beginners]
Line of Credit vs. Credit Cards
Credit cards and lines of credit serve a similar function in that they both provide access to revolving credit. However, these products are designed for different use cases. The biggest differences between lines of credit and credit cards are:
— Interest rates. Lines of credit generally offer lower interest rates than credit cards. For example, at U.S. Bank a personal line of credit starts as low as 11.5% annual percentage rate, while credit cards tend to start with APR ranges around 18%.
— Payment schedules. While credit cards typically require a minimum monthly payment of 2%-3% of your balance, lines of credit may have more flexible terms. With a home equity line of credit, for example, you may have a 10-year draw period before your repayment period begins.
— Access to funds. Credit cards offer access to your funds through a physical payment card, while lines of credit do not. Typically, you’ll need to write a check, use an ATM or make a bank transfer to access line of credit funds.
When to Use a Line of Credit
Lines of credit tend to work well for large, ongoing expenses. With the ability to tap into your credit line as needed over a long period, a line of credit may work well for situations like:
— Large, expected expenses. A line of credit could be helpful if you’re trying to figure out how to pay for big purchases like wedding costs, education expenses or home renovation projects. This method is often better than a traditional loan because you only pay interest on charges as you borrow, rather than borrowing one lump sum that immediately starts accruing interest.
— Business costs. For a small business owner, a replenishing source of funds can help manage cash flow. The ability to borrow funds to make ends meet during slower periods can keep a business afloat until sales pick up. A line of credit can also be a good way to support scaling goals.
— Debt consolidation. Debt can be overwhelming, especially when you have multiple sources of high-interest debt, like credit cards. Lines of credit are a popular method of debt consolidation, achieving two things: condensing multiple bills into one and reducing your interest rate. Because lines of credit typically come with lower interest rates than credit cards, using this strategy can save you money as you work toward a $0 balance.
[Read: Best Debt Consolidation Loans.]
When to Use a Credit Card
Due to ease of use, credit cards are best for everyday spending and purchases that you intend on paying back before they start accumulating interest. Here are a few reasons why:
— Convenience. Unlike a line of credit, a credit card offers a physical payment card, making it easy to tap and go at in-person stores.
— Rewards. Cash back, points and miles are a perk you won’t find with a line of credit. If you’re going to make a $2,000 purchase, you might as well put it on a rewards credit card and earn 2% cash back. The exception would be if you weren’t able to pay that purchase off immediately.
— Intro APR. Another reason you might want to use a credit card over a line of credit is to take advantage of a 0% APR offer. Credit card issuers use these introductory offers to entice new cardholders with 12 or more months to borrow interest-free. These offers are less common in lines of credit. Even a 1% APR difference can translate to a large sum over time.
[Read: Best Low-Interest Credit Cards.]
How to Choose Between a Line of Credit and a Credit Card
Deciding between these two funding sources can be tricky since they’re similar in structure, but the right decision depends on a combination of factors.
“When choosing between a credit card and a line of credit, it is essential to consider your specific financial context,” says Ryan J. Marshall, a certified financial planner at ELA Financial Group.
Start by assessing how much you need to borrow and the timeline you’ll need for repayment. In general, a line of credit is best for larger amounts that require extended repayment periods, while credit cards are best for smaller amounts and shorter repayment periods.
“Credit cards provide convenience and short-term flexibility, making them well-suited for everyday purchases or rewards-based spending. However, their high interest rates can quickly lead to significant debt if balances are not paid in full each month,” says Marshall.
Pick two real products and run the numbers through a debt calculator to see the difference in total repayment amount. Many credit cards and lines of credit offer prequalification, which can give you a good idea of the terms and rates you’re qualified for before you actually apply.
The Bottom Line
Lines of credit shine as a generally lower-cost source of financing for larger amounts over time, while credit cards are more convenient to use and can offer rewards and 0% APR introductory periods.
“It is essential to understand the terms, repayment requirements and interest rates for both,” says David Shipper, vice president and branch manager at Benjamin F. Edwards Wealth Management. “And it’s also important to shop around rather than apply for the first product you see. With a little extra effort, you are likely to find a product that meets your needs and offers competitive terms.”
The right choice for you is the option that offers the features you need at the lowest borrowing cost. So do your research, run the numbers and make your decision based on your financial situation and goals.
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Line of Credit vs. Credit Card: How They Compare and When to Use Each originally appeared on usnews.com
