Fixed Term Loan vs Line of Credit: Which Financing Option is Better For You?

When it comes to financing large purchases or projects, two popular options are fixed term loans and lines of credit. Both allow you to borrow money, but they work differently As you evaluate financing options, it’s important to understand the key differences between fixed term loans and lines of credit

I’ll compare these two financing methods in this article looking at how they work their pros and cons, costs, qualification requirements, and ideal uses. My goal is to provide a clear overview so you can determine which option may be better suited for your needs.

How Do Fixed Term Loans Work?

With a fixed term loan, you borrow a lump sum amount upfront and repay it in fixed monthly installments over a set period of time (the term). Common term lengths are 2 to 7 years.

Once approved, the lender deposits the full loan amount into your bank account. Repayment begins immediately, with your monthly payments going toward both principal and interest. The interest rate and monthly payments stay the same over the life of the loan.

Fixed term loans can be secured (requiring collateral like your home or car) or unsecured. Unsecured loans are more widely available and don’t put your assets at risk if you default.

How Do Lines of Credit Work?

A line of credit provides ongoing access to borrowed funds up to a set credit limit. It works similarly to a credit card. You can draw from the line as needed, and you only pay interest on the amount you actually borrow.

Lines of credit have a draw period (usually 5-10 years) when you can access funds, and a repayment period when you can no longer draw and must pay off your balance. During the draw period you make minimum monthly payments.

The interest rate is variable, meaning it fluctuates based on market conditions. The rate adjusts periodically, so your interest costs and minimum payments can go up or down over time.

Key Differences Between Fixed Term Loans and Lines of Credit

Loan amount: Fixed term loans provide a lump sum. Lines of credit give you ongoing access up to a credit limit.

Interest rate: Fixed term loans have a fixed rate. Lines of credit have a variable rate.

Repayment: Fixed term loans have set monthly installments. Lines of credit have flexible payments during the draw period.

Fees: Fixed term loans may charge origination fees. Lines of credit may have annual fees.

Qualification: It’s often easier to qualify for a fixed term loan. Lines of credit usually require higher credit scores.

Usage: Fixed term loans provide a lump you repay over time. Lines allow flexible ongoing access to borrowed funds.

Pros and Cons of Fixed Term Loans

Pros

• Interest rate and payments stay the same over the loan term
• Can be used for almost any purpose
• Often easier to qualify compared to lines of credit

Cons

• You pay interest on the full amount even if you don’t end up using all the funds
• Lump sum may provide more than you need
• Late fees if you miss payments
• Possible origination fee

Pros and Cons of Lines of Credit

Pros

• Access funds as needed instead of a lump sum
• Only pay interest on what you borrow
• Can reuse funds as you repay your balance
• Flexible payments during draw period

Cons

• Variable rate means costs can go up over time
• Typically need good credit to qualify
• Possible annual and overlimit fees
• Can be tempting to overspend

Costs of Fixed Term Loans vs Lines of Credit

Interest rates: Expect rates of 5-36% for fixed term loans and 10% or higher for lines of credit. Your personal rate depends on creditworthiness.

Fees: Fixed term loans may charge 1-8% origination fees. Lines of credit can have annual fees of $50-$100+.

Penalty fees: Both carry late fees if you miss payments. Lines of credit also charge overlimit fees if you exceed your credit limit.

Ongoing costs: With fixed term loans, your monthly payment stays the same. Lines of credit have variable rates, so your interest costs and minimum payments can change.

Qualification Requirements

You’ll generally need a higher credit score and income to qualify for a line of credit compared to a fixed term loan.

Fixed term loans typically require:

• Minimum credit score of 580
• Steady income
• Low debt-to-income ratio

Lines of credit often require:

• Minimum credit score around 670+
• Strong income and credit history
• Lower debt-to-income ratio

Meeting the minimum requirements doesn’t guarantee approval. Aim for the best terms by having a high credit score, low debt, and substantial income.

Ideal Uses for Each Option

Fixed term loans work well for:

• Major one-time expenses like home renovations
• Consolidating high-interest debt
• Major purchases like medical procedures or autos
• Any situation where you know the exact loan amount needed

Lines of credit are good for:

• Ongoing expenses that vary month-to-month
• Building an emergency fund
• Short-term financing needs
• Projects with unclear costs
• Situations where you want funding flexibility

Which Option Is Better For You?

There’s no definitively “better” option. It depends on your needs and financial situation.

Fixed term loans provide predictable costs but less flexibility. Lines of credit offer flexibility but variable rates.

Think about your budget, credit score, planned usage, and repayment timeline. This can help determine if a fixed term loan or line of credit better suits your circumstances.

Comparing loan details like rates, fees, and lender options can also inform your decision. Get prequalified to see available offers. Doing your homework upfront will set you up for success.

The most important thing is choosing an affordable financing option that fits your goals. With a clear understanding of how fixed term loans and lines of credit work, you can make a well-informed decision.