Personal Loans Vs. Credit Cards: Which Is Better For You?
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When unexpected expenses have the potential to derail your finances, you are not alone. According to a study from the Federal Reserve, only 63% of adults said they had the funds to pay an unplanned $ 400 expense without going into debt. The rest – more than two in three Americans – would have to write those costs down on a credit card they couldn’t pay off in the next billing cycle, or would have to borrow money in some other way.
And that’s according to a survey conducted in 2019 before the pandemic devastated the economy.
If you’re in a similar situation – either you don’t have enough savings to cover your financial plight or you don’t want to touch the money in this account – there are two options you should consider when you have large expenses to cover: a personal loan or a credit card. A personal loan can also be a good idea if you want to consolidate debts into a single payment with lower interest rates.
There are important differences between the two, as well as advantages and disadvantages of each choice.
When should a personal loan be used?
A personal loan can be obtained from a local bank or credit union, or from an online lender.
Almost anything can be paid for with the funds, with experts warning against unnecessary borrowing.
“Personal loans are often used for debt consolidation, where multiple payments like medical bills or credit card balances are combined into a single monthly payment,” says Amy Vos, a financial advisor at Northwestern Mutual. “Other common ways to use a personal loan are vehicle finance, small business finance, and home improvement.”
But a personal loan can come in handy in a variety of other scenarios.
For example, it can be used in the event of an unexpected breakdown – your home needs a new roof, your car needs a new engine, or you have a medical emergency that is not insured. A personal loan can also be used to pay tuition fees if you are not eligible for a student loan or if it is late to receive the funds.
Advantages and disadvantages of a personal loan
A personal loan has several advantages. For example, when you consolidate your debt, you no longer have to meet multiple due dates.
“Combining multiple payments into a single monthly payment simplifies and organizes your finances,” says Vos. However, this only makes sense if the interest rate on your personal loan is lower than the interest rate on your current debt.
Because personal loans are repaid in fixed, regular installments, they can provide consistency, which is important when trying to manage a budget.
“In contrast to a credit card, the payment is always made at the same rate,” says Vos.
You may also pay less overall. “Personal loans could potentially have lower interest rates than many credit cards, but also a higher credit limit,” says Leslie Tayne, founder and chief attorney of Tayne Law Group, a law firm that specializes in helping people pay off debt. So transferring balances from high yield credit cards to a low interest loan can save you thousands of dollars depending on the loan size.
In addition, if you have sufficient credit, you can get an unsecured personal loan i.e.
However, there are also disadvantages to taking out a personal loan. If you don’t have good credit, it will be difficult to qualify for a low interest rate personal loan, warns Tayne. The interest on a personal loan with bad credit can be as high as a high-interest credit card.
“When it comes to personal loans, there are also fees to consider, such as processing fees and repayment fees that are charged in the event of early repayment of the loan amount,” says Tayne. (Not all personal loans incur early repayment fees.)
You may also have higher monthly payments than a credit card, as the loan usually has to be paid off in a relatively short period of one to five years.
When to use a credit card
Credit cards are perhaps the most popular form of debt in America. There were 497 million credit card accounts in the U.S. in 2020 Experience.
The consumer credit bureau also found that the average credit card limit in 2020 was $ 30,365 and the average credit card balance was $ 5,315.
Credit cards can be used for almost anything. They can be substituted in pretty much any scenario where a personal loan would apply.
0% APR credit cards are essentially a zero-interest loan, but you need a decent loan to get approved for one – and a plan to repay it before the introductory period ends.
Advantages and disadvantages of credit cards
When time is of the essence, a credit card application can lead to a credit line approval much faster than a personal loan. “It’s an incredibly quick approval process,” said Justin Goldman, co-founder and CEO of RenoFi in Philadelphia. You cannot know in advance what credit limit a new card will have, although applicants with better credit scores are usually admitted to higher limits.
That quick approval, which gives you the ability to spend thousands in days without actually paying later, can be dangerously enticing – and credit card balances can have high interest rates too. “If you’re planning on paying it off quickly, the high interest rate can’t be a big deal in the short term,” Goldman says.
The interest rate on a credit card (as well as on a personal loan) depends on your creditworthiness, and if it’s good you can qualify for a card with an introductory rate of 0%. A card with an interest-free introductory period allows you to postpone payment for a year, sometimes longer.
“If you can find a credit card that has an initial 12 month interest-free period, and you can afford to pay off the project during those 12 months, credit cards can be a valid option,” says Zachary A. Bachner, CFP, a consultant at Summit Finances in Sterling Heights, Michigan.
You can also get credit cards tailored to your interests and lifestyle preferences that give you bonus rewards for spending in certain categories, such as restaurants, groceries, or gasoline. You can then use these rewards – cashback, points, or airline miles – to offset the cost of some purchases or to travel for free.
“If your credit card has cashback for purchases, reward points, and / or frequent flyer miles, it can make sense to use them to reap the benefits,” says Tayne.
“A credit card also provides protection against fraudulent charges on your account,” says Tayne. Another benefit of credit cards is that consistent, on-time payments can increase your credit score, she adds.
One major disadvantage of credit cards: fees.
Many credit cards have annual fees that can be more than $ 500 for some premium travel award cards. If you use a credit card to get a cash advance from an ATM or bank – an amount that you would borrow against the card’s credit limit – you will also be charged a cash advance fee, which can be up to 5% of the amount deducted. In addition, the interest on this cash advance is usually higher than the interest on card balance.
Additionally, if you miss a credit card payment, you will be charged a late payment fee, although many credit card companies may waive the fee the first time you are late when asked. And if you exceed the credit limit on the card, you may be charged a fee for exceeding the limit, unless your account is set to decline the transaction if your limit is exceeded.
Even cards with an introductory period of 0% APR that allow you to transfer interest-bearing balances from other cards will still charge you a fee. These transfer fees can be up to 5% of the transferred amount.
Credit cards are also quite expensive if you don’t pay your balance on every billing cycle. According to the Federal Reserve, the average credit card interest rate is 14.65%. Applied to the average American balance on their credit cards, which is about $ 5,300, it means the average card customer would pay $ 800 each year to carry that balance – and that’s if the balance didn’t grow which would lead to higher interest payment.
Even if you get an introductory rate of 0%, the rate will skyrocket after the introductory period is over. And if you make late payments or exceed the limit, credit card companies can increase your interest in so-called Penalty APR.
The lure of rewards can also lead people to spend more than they can afford. “If you use your card to get rewards and then withdraw your balance every month, that’s fine,” says Vos. However, if you carry a balance each month and pay the interest on it, you will likely negate any savings from your premiums.
Alternatives to personal loans and credit cards
In addition to a personal loan and credit cards, there are other options to choose from.
- Peer-to-Peer Lending Providing money from investors rather than traditional lenders and not needing a perfect loan.
- Life insurance loans allow you to borrow accumulated money from some life insurance policies. Life insurance can also serve as security for a bank loan.
- 401 (k) loan do not contain any applications or approval processes. However, since you are borrowing money from your retirement, this is a last resort and we do not recommend it except in certain cases.
Personal loans and credit cards can provide cash when you are in need or don’t want to tap into your cash reserves. However, you need a good credit score for a personal loan and a clear understanding that credit cards work best when you are out of balance.