Choosing Your Credit Wisely: Personal Loans vs. Credit Cards
For every type of purchase you make, it’s important to choose the more suitable option between loan funds and a line of credit. Align the choice with your financial goals and needs and remember to make payments on time so you don’t hurt your credit score or lose any collateral assets.
Ideally, personal loans should be used for:
- Large purchases
- Consolidating high-interest debt
- Obtaining low-interest loans if you have good credit
Meanwhile, credit cards may be better for:
- Short-term needs
- Smaller expenses you can quickly repay
- The introductory 0% APR period
Credit cards and personal loans are two distinct financial tools that can help you access funding when you don’t have enough money. Credit cards offer convenience and alluring rewards programs, but come with higher interest rates and other drawbacks. Loans allow you to make major purchases and consolidate debt but can damage your credit score if you aren’t careful.
Let’s go over the pros and cons of personal loans versus credit cards so you can make informed decisions when navigating the world of loans and credit.
Understanding personal loans
Definition of personal loans
Personal loans are installment loans for the individual consumer, offered by banks, online lenders, credit unions, and other financial institutions. If you’re approved for a personal loan, a lump sum of funds will be directly deposited into your bank account. You can use the loan funds for a wide range of purposes, including:
- Debt consolidation
- Large purchases
- Emergency bills
Typical terms, interest rates, and repayment schedules
Most personal loans have fixed interest rates, so the repayment installment remains the same each month. While the loan term varies based on the loan provider, it typically lasts two to seven years.
Personal loans may be either secured or unsecured by collateral assets. A secured loan with collateral is usually easier to obtain and has more favorable interest rates. However, the valuable collateral can be seized by the lender if you default on the loan.
An advantage to obtaining a fixed-rate loan is the predictability of the repayment schedule. The fixed installments each month encourage better financial management through structured debt repayment.
Ideal scenarios for a personal loan
Debt consolidation: Compared to credit cards, personal loans are the better way to consolidate debt. You can roll multiple high-interest debts into a single one with lower interest using a personal loan.
Good credit: If you have good to excellent credit scores, it’s advisable to opt for a personal loan instead of a credit card. You can leverage your good credit to qualify for loans with more favorable terms and lower interest rates. The interest rates of credit cards aren’t affected by your creditworthiness as much.
If you have a high credit utilization ratio: For those with high credit utilization already, it might not be a good idea to use more of your revolving credit.
Understanding credit cards
Credit cards are metal or plastic cards issued by financial institutions to approved cardholders. A credit card allows you to make purchases using a revolving line of credit. You can keep accessing the line of credit until you meet the card’s maximum credit limit.
Types of credit cards
There are many different types of credit cards. Here are the most common ones:
- Rewards credit cards
- Low-interest credit cards
- Balance transfer credit cards
- Student credit cards
The average interest rate of all new credit cards in the United States is around 24.5 percent. The interest rate varies based on market rates, the type of credit card, and your creditworthiness.
Promotional credit card offers often offer an introductory zero interest rate for 12 to 18 months. If you open up a credit card account, make sure you take advantage of promotional offers. Just make sure you read the fine print so you know the rates and terms of the credit card once the zero-interest period ends.
Each monthly billing cycle, a small minimum payment is due. Paying this minimum payment helps you avoid late fees and penalties. However, it’s critical to know that you will still be charged interest on any balance you carry. It’s good practice to pay down your credit card balance as much as possible.
The credit limit is how much credit you’re allowed to access. Over time, your credit limit will go up as you build better credit. However, if your credit utilization is too high, it can hurt your credit score and result in credit limitations.
Credit utilization accounts for around 30 percent of your credit score. Because of this, it’s good practice to keep a credit utilization ratio as low as possible.
Your credit utilization ratio (CUR) is used for various borrowing and credit-checking purposes. If you have a CUR exceeding 43 percent, it becomes challenging to qualify for loans.
When is using a credit card advantageous?
Convenient payments: Credit cards are great for smaller transactions that can be quickly paid off. They’re also invaluable for emergencies when you don’t have cash and have no time to obtain a loan.
Credit-building: If you want to build credit, opening up a credit card account is a straightforward, simple way to establish credit. As long as you well manage your credit card balance and make regular, on-time payments to keep it low, you can show creditors that you have good financial habits. Try to always at least make the minimum payment.
Sign-up bonuses and rewards: Many credit card companies offer promotions to new cardholders. Ongoing rewards can also help you get cash back on purchases.
Interest rates and fees
Interest rates for personal loans vs credit cards
Personal loan interest rates vary greatly between 6 and 36 percent based on numerous factors, such as your creditworthiness and loan purpose.
Credit cards usually have interest rates between 20 and 25 percent.
Compound interest on credit cards vs. simple interest on personal loans
Compound interest: Credit cards use compound interest, which means interest is always applied to the outstanding balance. You will need to pay interest on accrued interest plus the principal balance. This makes it very easy to accumulate significant interest on a credit card if you can’t pay down the balance quickly.
__Simple interest: Personal loans usually use simple interest, which is calculated as a percentage of the principal loan amount (the initial amount borrowed).
Different types of fees
Common personal loan fees:
- Late payment fee
- Origination fee
- Prepayment penalty
Common credit card fees:
- Annual fee
- Late payment fee
- Card replacement fee
- Over-limit fee
- Cash advance fee
- Foreign transaction fee
Repayment structure and terms
Personal loan fixed repayment schedule
Personal loans have loan tenures between two and seven years, giving you ample time to pay off the debt. It is easier to budget for personal loan repayment due to the fixed interest rates.
Credit card flexibility and pitfalls
Credit cards only require you to send in the minimum required payment every billing cycle. If you can’t afford more, it’s not mandatory to pay off the entire balance each month. This flexibility can help individuals who have fluctuating income.
However, the high compound interest rates of credit cards make it easy to spiral into credit card debt. An overreliance on credit cards can lead to financial hardship and high-interest debt.
The influence of credit scores
How loans and credit cards affect your credit score
Personal loans: The initial credit check when you apply for a personal loan can drop your credit score by around five points. For this reason, it’s ideal to gain pre-qualification or pre-approval for a loan before formally submitting a loan application.
As you make regular, on-time payments to repay the loan, you can gradually increase your credit score. However, missing a payment can seriously damage your credit score. Defaulting on a loan can drop your credit score by up to a hundred points, resulting in long-term financial problems and risks.
Credit cards: When applying for a credit card, the card issuer may perform a hard inquiry that dips your credit temporarily. If you frequently max out your credit card or maintain a high credit utilization ratio, your credit score can decrease due to perceived poor financial management skills.
Having high credit utilization can hurt your credit score over time. Once you pay down the credit card balance and maintain low credit usage, you can raise your credit score back up.
If you want to establish credit, always try to make payments on time. Whether this is paying the minimum payment for credit cards or the installment for loans, on-time payments play a major role in improving your creditworthiness.
Funding and access to cash
Funding speed of personal loans
Personal loan funding is quick, with loan funds typically taking one to three business days to be disbursed into your bank account.
Credit card cash advance
An advantage of credit cards is the ability to obtain a cash advance. This allows you to withdraw cash immediately, covering urgent expenses.
If you’re hesitating between using a credit card and taking out a loan, consider the convenience factor of each financial tool. If you already possess a credit card and need to make a quick transaction, it’s naturally more convenient to use your credit card.
The role of debt consolidation
Using personal loans for consolidating debt
Consolidating debt using a personal loan is convenient and can help you save over time. The benefits include:
- A single, lower interest rate for all your consolidated debt
- Fixed repayment schedule for predictability
- Encourages responsible credit behavior and credit score improvement
- Credit score requirements
- Origination fees
- Not suitable for short-term debt
Using balance transfer credit cards for consolidating debt
The benefits of using a balance transfer credit card for debt consolidation include:
- Good for short-term debt
- Save on interest in the short run
- Rewards or cash-back programs
- Flexible repayment structure
The cons include:
- Limited timeframe for debt repayment
- High interest rate after the introductory period
- Credit limits
- Balance transfer fees
Evaluating your debt situation
Assess your situation to determine the best debt consolidation choice for you. If you have multiple high-interest debts, it might be better to roll them together using a lower interest personal loan.
On the other hand, a balance transfer credit card may be better if you expect to pay off the consolidated debts quickly enough to benefit from the promotional period. Many credit cards used for balance transfers offer introductory 0% APR. The interest-free period allows you to save money if you can manage to pay off the consolidated debt within that time.
Rewards, protections, and bonuses
Credit card rewards programs
Many credit card issuers offer rewards programs to improve customer loyalty. You may be able to earn points, miles, or cash back on eligible purchases. The more you spend, the more rewards you can receive. Points may be redeemed for statement credits, travel, and more depending on your reward program.
Cardholders can also take advantage of the additional perks provided by their credit cards, such as airport lounge access, exclusive deals with partners, and other services.
Credit cards are well known for their robust fraud protection services. If you report or respond quickly to unauthorized access to your credit card (e.g. your card was stolen), you’re typically not held responsible for the fraudulent credit usage. This gives great peace of mind to cardholders.
Purchase protection is another type of credit card protection that can be advantageous. It covers eligible purchases you make with the card from damage or theft for a designated period post-purchase.
Personal loans vs. credit cards
While personal loans don’t come with rewards programs or cash back, they often have lower interest rates. If you have good credit or need to make a major purchase, consider taking out a loan instead of using your credit card. The potentially lower interest rate of a personal loan can help you save a significant amount of money in the long run.
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