Knowing when to take out a personal loan and when to use a credit card can help you avoid financial problems in the future. While both are convenient ways to deal with unexpected expenses or large purchases, there are big differences in how you pay back the money you borrow.
If you need to borrow a large sum for a project or want to pay off high-interest credit card debt, you may want to consider a personal loan. For small everyday purchases, a credit card is a better option.
Personal loans and credit cards
A personal loan gives you a lump sum of money, minus fees if applicable. You pay a set amount every month until the balance is paid. Loans are typically used for large expenses or debt consolidation.
A credit card is a revolving line of credit, meaning you can borrow funds repeatedly up to a predetermined limit, called your credit limit. For this reason, credit cards are usually best for making ongoing, everyday purchases.
The main differences between personal loans and credit cards
When comparing personal loans and credit cards, check the repayment terms, interest rates, and how you can withdraw your funds. These are important factors in determining which is better for your money.
| Personal Loans | Credit card | |
|---|---|---|
| Average interest rate | 12.35% | 20.78% |
| Repayment Terms | Make fixed monthly payments over a fixed term, usually between 12 and 84 months | Pay the minimum or full outstanding balance by the due date each month |
| Types of interest rates | Fixed interest rate for the entire loan | Floating interest accrues on unpaid balances |
| How funds are distributed | Lump sum payment: You can receive the entire loan amount in one lump sum | Revolving credit line: Available up to your credit limit |
| Fee | Fees, prepayment fees, late fees, etc. | Annual fees, late fees, fees for exceeding the limit, overseas transaction fees, etc. |
While there are many differences between personal loans and credit cards to consider, they also have some important similarities. Both are ways of borrowing money that must be repaid in monthly installments. Irregular or late payments can not only prevent you from borrowing in the future, but they can also disqualify you from housing or even a job.
When to take out a personal loan
Personal loans tend to have lower interest rates than credit cards and are intended for large, one-time expenses.
Taking out a personal loan makes the most sense when you know you can make monthly payments over the life of the loan. You can use a personal loan calculator to estimate what your payments will be based on the loan term and interest rate.
Some common reasons for taking out a personal loan include:
- Consolidation of high-interest debt
- Paying unexpected medical bills
- Completing a home improvement project
- Pay for the wedding
Unfortunately, there are times when the risks of taking out a personal loan outweigh the potential benefits. Shopping therapy, meeting basic needs, and expensive travel are discouraged.
Pros and Cons of Personal Loans
Knowing the pros and cons of personal loans can help you make an informed decision before using this form of financing.
Strong Points
- Average APR drops significantly
- Ideal for debt consolidation
- Consistent monthly payments
Cons
- No rewards, points or other benefits
- Multiple Fees
- There may be strict eligibility requirements
How a personal loan affects your credit
Depending on how you use a personal loan, it can have a positive or negative impact on your credit score. When you apply for a loan, a hard query will be recorded on your credit report, which can temporarily lower your score by up to four points. The query will remain on your credit report for up to two years, but will no longer affect your score after 12 months.
However, your repayment history makes up 35 percent of your credit score, so paying off your loans on time can improve your credit score. Consolidating high-interest debt with a personal loan can also lower your credit utilization ratio, which makes up 30 percent of your credit score, potentially improving your credit in the long run.
Who is a personal loan best suited for?
If you have good to excellent credit and need to refinance high-interest debt, taking out a personal loan may be a smart financial choice. Personal loans offer consistent payments and may be available at a lower interest rate than your current debt, which could save you hundreds of dollars or more.
A personal loan can also help you pay for important expenses that you can’t save for, like home renovations or wedding costs. Using a personal loan instead of a credit card is likely to mean you pay less interest, which is handy if you know exactly how much you need and don’t want to carry a balance on your card.
When to use a credit card
Credit cards offer rewards points for frequent use, making them a good choice for responsible everyday spending.
When it comes to using a credit card, paying your balance in full at the end of your billing cycle is important to your financial health. If you don’t pay your balance and your card doesn’t have a 0 percent introductory interest period, you’ll accrue interest. If you only make the minimum payments, it could take you a long time to pay off your balance.
For this reason, you should only use your credit card for purchases that you can be sure of paying for within a reasonable period of time.
There are several ways to use a credit card:
- Small everyday purchases
- Pay for a well-planned vacation
- Earn cash back and vacation points
- Take advantage of 0% interest rates
On the other hand, credit cards may not be the best way to pay for loan repayments, big-ticket purchases, medical bills, or other large unexpected payments.
Pros and Cons of Credit Cards
When used responsibly, credit cards can be a great way to earn rewards, cash back, and travel benefits. But they can also have a negative impact on your financial health. In fact, credit cards have a wide range of pros and cons.
Strong Points
- Earn rewards and bonuses
- Improve your credit rating
- Convenient for everyday expenses
Cons
- High Interest Rates
- Potential for overspending
- Multiple Related Charges
How credit cards affect your credit
Paying your credit card bills on time each month builds a history of on-time payments that can help your credit score over time. You can also boost your credit score if you have long-standing credit card lines that you’ve had open for several years. The length of your credit history accounts for 15 percent of your FICO score, especially if you keep your accounts in good standing.
However, being more than 30 days late on a payment can hurt your credit, and carrying high balances on your cards will increase your credit utilization ratio and lower your credit score. It’s generally a good idea to keep this ratio below 30 percent if possible.
Personal Loans and Credit Card Alternatives
Personal loans and credit cards aren’t the only ways to raise funds: mortgages, lines of credit, and cash advances can also be convenient ways to cover big expenses.
- Mortgage: A home equity loan allows you to borrow a lump sum of money using the equity in your home. Home equity loans can be used for a variety of purposes, including home improvement projects or debt consolidation.
- HELOC: A home equity line of credit (HELOC) also uses the equity in your home, but it works like a credit card. With a HELOC, you’re given a line of credit and can draw on as much money as you need, when you need it. This is great for ongoing home improvement projects or expenses.
- Personal line of credit: Similar to a credit card, a personal line of credit is a more flexible type of personal loan. You can withdraw funds from the loan as needed and pay back the remaining balance with interest. Common uses for a personal line of credit include financing unexpected expenses or large purchases.
- Cash advances: Many credit card issuers offer cash advances, which allow you to withdraw cash up to your credit card limit. The interest rate charged on cash advances is usually higher than the interest rate charged on purchases, so be sure to check before withdrawing.
Conclusion
Credit cards are convenient because they allow you to earn points on everyday purchases, but they can add up to debt if you spend beyond your budget. The same is true with personal loans. Before deciding whether a personal loan or credit card is right for you, research all your options, get pre-qualified, and compare the interest rates and fees of each product.
Also, keep in mind that using both is an option: for example, you could take out a personal loan for one-time purchases and apply for a credit card for regular expenses.
