Making a large purchase or dealing with an unexpected expense can be difficult, and choosing between a personal loan or a credit card may not be easy. However, understanding the differences between the two can help you make a decision and avoid financial challenges.
There are a few different options to consider when it comes to taking out money for a large project or paying off high-interest credit card debt. A loan can be a good option, but it’s not the only choice. Another option is to use a credit card.
Differences between a personal loan and a credit card
Getting personal loans can help you in two ways: first, by providing you with the lump-sum payment, you need for your expenses, and second, by allowing you to consolidate your debts into one monthly payment.
Credit cards have many benefits, including the ability to borrow money up to your credit limit, make daily purchases, and have access to revolving credit. Credit cards can be very helpful in managing your finances and budgeting for future expenses.
When choosing which route to take, be aware of the following key differences:
| Credit cards | Personal Loans | |
|---|---|---|
| Repayment terms | You can pay the minimum amount or the total accrued balance by the monthly due date | Fixed monthly payments over a set period of time, usually between 12 and 60 months |
| Interest | Variable interest that accrues on unpaid balances | Fixed interest over the entirety of the loan |
| Funds disbursement | You have access to your monthly credit limit | You will receive the full loan amount at once |
| Fees | Annual fees, late fees, over-limit fees, and foreign transaction fees, among others | Origination fees, prepayment fees, late fees, etc. |
There are many key differences between personal loans and credit cards that consumers should be aware of. However, there are also some important similarities between the two that are worth considering.
“There are many benefits to using a credit card or a loan,” says Jeff Arevalo, financial wellness expert for GreenPath Financial Wellness. “You can purchase now and pay later, which can help you conserve cash. Just be sure to make your payments on time and use responsibly so as not to negatively affect your credit or ability to secure future funding.”
Personal loans
A few things to consider before you take out a personal loan, such as whether or not you can afford the monthly payments.
There are a few reasons you might need to take out a loan, such as:
- Consolidate high-interest debt
- Pay unexpected medical bills
- Complete home improvement projects
- Cover wedding costs
There are times when a personal loan may not be the best idea.
- Finance unnecessary expenses
- Cover everyday expenses and basic needs
- Retail therapy
- Federal student loan payoff
Pros and cons of a personal loan
Before you take out a loan, it’s important to understand the potential advantages and disadvantages. This way, you can make a more informed decision about whether this form of financing is right for you.
Pros
- Versatility
- A good option for debt consolidation
- Consistent monthly payments
Cons
- Potentially high-interest rates
- Added debt
How personal loans affect your credit
Personal loans can impact your credit score in different ways, positive or negative, based on how you use them. A hard inquiry will show up on your credit report when you apply for a loan and can lower your score by a few points, though this is only temporary. The inquiry will stay on your report for up to two years but won’t have an effect after the first twelve months.
Paying off your loan on time can help improve your credit score. This is because payment history is a big factor in determining your credit score – it makes up 35% of the total. Consolidating high-interest debt with a loan can also lower your credit utilization ratio, which is another 30% of your credit score. So by taking these two steps, you could see a significant improvement in your credit rating.
It’s important to make sure you can afford a loan prior to taking one out. A single missed payment can result in the lender reporting it to one of the three main credit bureaus, which could then negatively impact your credit score. Since payment history is responsible for 35% of your credit score, it’s crucial to be mindful of this when considering a loan.
Who a personal loan is best for
Personal loans can be a great way to pay off a large expense or consolidate high-interest debt, especially when you have good to excellent credit. With a loan, you’ll likely pay less interest than you would with a credit card, making it a wise financial choice.
“When it comes to taking out a loan, you should always think of it as a tool,” said Steve Sexton, CEO of Sexton Advisory Group. “A loan can be used for many things such as paying off medical expenses, credit card debt, or other loans. The point of taking out a loan is to help ease the financial burden when you have overspent. With that in mind, it’s important to have a plan in place so that you can pay off the debt.”
Personal loans are best used when you can avoid late payment fees or damage to your credit score. On-time monthly payments will help you keep your loan in good standing.
Credit cards
Using a credit card wisely is key to maintaining good financial health. One of the most important things you can do is to pay off your balance in full at the end of each billing cycle. This prevents interest from accruing and helps you avoid paying for purchases for a long time.
It’s important to only use your credit card for purchases you’re confident you can pay off.
There are some things that you should use your credit card for:
- Make smaller everyday purchases
- Pay for a well-planned vacation
- Earn cash back
- Take advantage of the 0 percent interest opportunity
When not to use a credit card
- Cover unexpected medical bills
- Make large purchases
- Pay off loans
Pros and cons of a credit card
Credit cards can be great for earning rewards, cash back, and travel benefits. But they can also negatively impact your financial health. Use them responsibly to avoid unwanted debt and fees.
Pros
- Earn rewards and bonuses
- Boost your credit rating
- Convenience
Cons
- High-interest rates
- Potential for more debt
- Associated fees
How credit cards affect your credit
Building a history of on-time credit card payments is one way to improve your credit score over time.
Making late payments on your credit card can have a negative impact on your credit score. Keeping a high balance on your card can also lead to a lower credit score. It’s generally advisable to keep your credit utilization ratio below 30%, or 10% ideally. For example, with $20,000 in available credit, you should use less than $6,000 to maintain a good credit score. Keeping the balance under $2,000 is even better for your credit score.
Adem Selita, CEO, and co-founder of The Debt Relief Company, explains that your credit score can be negatively impacted by using too much of your available credit. However, he also notes that having high credit limits and not utilizing all of the available credit can actually be a positive for your score.
One way to improve your credit score is to keep open lines of credit that have been established for several years. This is seen as favorable by credit bureaus and can give your score a boost, especially if you have kept the accounts in good standing.
Alternatives to a personal loan or a credit card
There are many ways to access funds, besides taking out a loan or using a credit card. Here are some other options to consider:
- Home equity loan: Home equity loans are an excellent way to finance large purchases or consolidate debt. Using the equity you’ve built up in your home, you can borrow money from home improvement projects to pay off high-interest debt.
- HELOC: Home equity lines of credit, or HELOCs, are similar to home equity loans in that they use the value of your home as collateral. However, HELOCs work more like credit cards, allowing you to withdraw funds as needed up to your credit limit. This makes them ideal for funding ongoing home improvement projects or other expenses.
- A personal line of credit: Personal lines of credit are becoming increasingly popular as an alternative to traditional personal loans. Like credit cards, they offer the convenience of drawing from the loan as needed and paying back the balance with interest. However, personal lines of credit can also be used for major purchases or unexpected expenses, making them even more versatile than credit cards.
- Cash advance: Many credit card issuers offer cash advance features that allow you to withdraw money against your credit limit. However, the interest rates charged for cash advances are usually higher than those applied to purchases, so it’s important to check with your lender beforehand to see what their rates and fees are.
Bottom line
Credit cards can be great for earning rewards on everyday purchases, but they can also lead to debt problems if you’re not careful. The same is true for personal loans – taking out more than you can afford to repay can put you in a difficult financial position.
There are a few things to consider when trying to decide whether a personal loan or credit card is right for you. Firstly, you should explore all of your options and compare the rates and fees for each product by getting prequalified. Secondly, think about whether it would be a smart idea to get a credit card or a loan ahead of making a large purchase. For example, applying for a mortgage while also taking out a large loan could impact your ability to qualify for the mortgage.
It’s important to do your research before applying for a credit card or a loan. By understanding the terms and conditions of each type of credit, you can make an informed decision about which one will work better for you.
