A line of credit, personal loan, and credit card are all unsecured lending instruments, implying that no collateral or collateral needs to be posted to use credit through any of the three.
How they work is simple: instead of relying on the borrower’s assets as collateral, lenders approve unsecured loans based on the borrower’s creditworthiness. If a borrower defaults or fails to repay an unsecured loan, the lender can settle the matter in court or appoint a collection agency to collect the loaned money.
Let’s see how a line of credit, personal loan and credit card work and how you can get one.
How does a line of credit work?
A line of credit is a form of unsecured loan, where you can access capital ranging from INR 5,000 to INR 2,00,000 or more in some cases.
It is a unique type of credit product that allows borrowers to avail a loan and use the required amount as per their needs, and only pay interest on the principal amount used instead of the total amount borrowed.
When the borrower repays the monthly payment or the EMI on the amount used, the entire line of credit is again available to him.
Here’s how a line of credit works:
- After the application process, you get approved for INR 80,000 on your line of credit. Out of the total amount of INR 80,000, you choose to use only INR 50,000.
- In this case, you will have to pay interest on INR 50,000, not the full INR 80,000.
- The money is a cash transfer to your bank account and you can use it for any need you may have.
- Once the first amount of INR 50,000 is used, the remaining line of credit available for use is reduced to INR 30,000 instead of INR 80,000.
- The repayment tenure of the loan amount ranges from two months to three years depending on the repayment capacity of the individual.
- Suppose you choose an installment repayment term of six months, you can repay the INR 50,000 in six months with interest. And when you start repaying, your credit limit is restored.
- After six months, the full limit is available again. Remember that you can borrow any amount for any term as long as it remains within your available limit.
- The interest rate varies depending on the amount of money borrowed and the term, but is generally similar to personal loans.
How does a personal loan work?
The majority of personal loans in India are unsecured, meaning they do not require collateral that borrowers submit when taking out a loan. Unsecured personal loans come in many forms but have one feature in common: they are disbursed as lump sum loans and you have to start paying interest on the full amount borrowed from the day you take out the loan.
Here are some examples of unsecured personal loans:
- A wedding loan is designed to fund all or some aspects of a wedding.
- A holiday loan is intended to finance a trip.
- A home renovation loan can be used to improve your home or parts of it.
- A sustainable consumer loan can be chosen to buy goods or electronic devices such as laptops, smartphones, washing machines, among others.
Here’s how a personal loan works:
- The duration of these loans is three years on average and goes up to five years in some cases. The repayment is mostly collected monthly and the financing company, banks or others, generally does not prefer that you repay your loan early.
- A prepayment penalty is charged if you close your loan early. The reason for this is simple: once the finance company understands that you are solvent, they prefer to collect as much interest as possible to recoup their costs and make a profit.
- Nevertheless, these types of loans are useful if you have a clear and urgent need for a large sum of money and you don’t mind paying the interest over the fixed term.
- The interest rate for a personal loan generally varies between 12% and 18% if you have a good credit rating. This interest rate on an unsecured loan can vary from lender to lender.
- Some lenders might charge interest rates as low as 7% and as high as 36%. But there are others who charge very high rates ranging from 150% to even 1000% and more with processing fees. These lenders operate in the payday lending space, meaning loans granted for very short terms, usually between 7 and 30 days.
- For unsecured loans, there are no collateral and hence there is no guaranteed income for the lender in case the borrower defaults. So here the risk becomes high for the lender. To adjust for this risk, lenders tend to charge a higher rate of interest on unsecured loans. However, a payment default will have an impact on the borrower’s credit rating.
- However, if you want to make this decision wisely, make sure you maintain a good credit score, ideally between 700 and 900. This will help you get more loan options at much lower interest rates. on time.
- Borrowers are advised to exercise caution when taking out a personal loan and they are encouraged to find out the precise details of their loan before contacting lenders.
How does a credit card work?
A credit card is a completely different product than a line of credit and a personal loan.
In layman’s terms, a credit card is simply a plastic card issued by a bank that you can use to make purchases and pay interest on the credit used with a predefined limit. You are billed monthly for the credit used and failure to pay the amount of the card or the bill within the time allowed results in interest on the credit used.
Here’s how a credit card works:
- If you pay your bill on time, you pay no interest, making it a convenient product to use. Some credit cards allow you to withdraw cash from an automated teller machine (ATM), just like a debit card.
- If you don’t pay your bill on time or only pay the minimum amount due or withdraw money via your credit card, you will incur interest rates of up to 38% to 42%, including fees and late fees.
- This interest rate on a credit card is almost twice as high as a personal loan.
- An attentive reader might wonder: if Mr. R buys for INR 1,000 today and pays his bills 30 days later, who pays the interest during those 30 days?
- The answer is simple: it is the tradesman with whom Mr. R did his shopping who pays this interest.
- Companies offering credit cards such as Visa and Mastercard make sure to collect 1% to 2% of the fee from where you shop which is used to fund the 30 days of interest-free shopping for the consumer. This is the reason why, even now, if Mr. R makes very large credit card transactions, some merchants will charge him a small fee. Otherwise, they will have to pay it out of their own pockets.
- The store or merchant pays the extra 2% because it has been proven time and time again that Mr. R will be buying a lot more using a credit card than doing cash transactions in the near future.
Steps to opt for a loan product
For a lender to offer you the most suitable product, you must follow a few simple steps:
- You must share your personal data with the proposed lender.
- The lender will extract your credit history via data provided by credit bureaus to determine if you have repaid your previous loans on time, tax returns to verify your repayment capacity and some other relevant documents to confirm your identity, such as the PAN card and Aadhaar card among others.
- After careful consideration, they will decide whether or not to issue you a loan product and set an interest rate based on the data they have.
- You will be able to choose between the best quotes that will be offered to you through your lender(s).
The larger idea behind any of the three unsecured loan products is to make borrowing less burdensome by making funds accessible to people in dire financial need. So if you choose one of the three loan products, ask lots of questions before signing up and always pay your dues on time.
In a nutshell, personal loans are generally better for larger one-time expenses that take longer to pay off. Credit cards are best for small expenses that can be paid off fairly quickly. This is because credit cards tend to have higher interest rates than personal loans, so it can be expensive to hold a balance on a card for a long time. However, a line of credit may be the best option for many customers when they have a frequent need for capital and are looking for the flexibility to have funds available to them as they need them.