For a lot of people, using credit cards is the go-to method when paying for just about anything. From groceries and gas to plane tickets and large electronics, using a credit card can be a hassle-free way to manage your expenses.
Plus, many cards offer rewards and perks. As long as you’re able to pay the balance each month to avoid paying high interest rates, credit cards are pretty convenient.
But what if you have expenses coming that you know you can’t pay off right away? Whether you’re hit with having to unexpectedly replace a laptop, cover a car or home repair, or pay for last-minute travel, sometimes big costs come up that you can’t anticipate. In those scenarios, you may wonder if using a credit card is your best option. After all, carrying a high balance on your credit card from month to month can be expensive.
According to Bankrate.com, the average credit card interest rate is over 17% . Plus, having a high credit card balance for a long period of time can hurt your credit score, making it harder to secure financing in the future.
When you have costs that will take you several months or longer to pay off, you may wonder: would a personal loan be better than a credit card for my situation? In this article, we’ll take a look at personal loans vs. credit cards.
We’ll also take a look at when one financing option might be better than another, and vice versa. This way, you can be better equipped to figure out which financing option fits your needs.
How Do Personal Loans Work?
When people think of a personal loan, they’re typically thinking of an unsecured loan that can be used for nearly any purpose. You receive the loan amount in a lump sum and are then required to make fixed monthly payments, typically for a term of two to five years (and sometimes longer). It’s worth noting that a personal loan is different from a revolving line of credit because it does have an end date.
Whether you make payments for two years or five years, you are chipping away at your loan with the intent of closing it out by the end of the loan term. However, you can pay off the loan earlier, sometimes without paying a penalty (you’ll want to check with your lender to make sure they don’t have prepayment penalties).
Unsecured personal loans offer fixed interest rates over the life of the loan. Variable rate personal loans are also an option, but their interest rates change based on market fluctuations. People paying off a personal loan over a longer time may not want to risk a variable rate loan because it’s hard to predict whether or not the interest rate will rise.
You can shop around online for a reputable lender and can typically apply online as well. For the application, you will likely have to give personal and employment information, possibly including proof of income such as a W2.
After you apply, it can take one or two business days (give or take) for the lender to review your application and make a decide whether or not to grant the loan.
If you are approved and agree to the terms of the loan, you sign a promissory note and receive the lump sum loan amount. After that point, you’ll be required to make payments on the loan.
Personal Loans vs. Credit Cards
There are a number of ways that an unsecured personal loan is different from a credit card. A credit card gives you access to a line of credit that you can borrow from as needed, up to your credit limit. You can pay back the total amount borrowed each month, or you can pay back less, but you’re generally charged interest on any balance that you carry from month-to-month.
Credit cards typically have a minimum payment that you’re required to make each month—that minimum payment might increase if you miss payments or carry a high balance relative to your credit limit.
In contrast, when you take out a personal loan, you receive a lump sum amount and agree to make installment payments over a set period of time. For this reason, a personal loan debt may be easier to manage than credit card debt.
Credit card debt is also known as “revolving debt,” meaning that you can continuously borrow up to your limit without paying the full balance back. If you carry a balance on your credit card each month, you could become stuck paying a high interest rate on your revolving debt.
One of the ways in which unsecured personal loans and credit cards are similar is that both financing options tend to come with higher interest rates than secured personal loans.
A secured loan, such as a mortgage, home equity line of credit (HELOC), or auto loan tends to have a lower interest rate, because it’s tied to an asset (like a house or a car) that the lender can take over should you be unable to repay the loan. Still, depending on your financial profile, you may be able to find an unsecured personal loan with a lower interest rate than a credit card.
When is a Credit Card a Good Option?
So, you might be wondering when a credit card could be a better option than a personal loan and vice versa. Using a credit card can be the most convenient of the two options since most people already have a card.
If you only need access to a few hundred or a few thousand dollars, and if you plan to be able to pay down your expenses completely over the course of just a few months, a credit card might be the easiest choice.
Personal loans also may come with what’s called an “origination fee” which is a one-time fee due at closing (or when you receive the lump sum). The origination fee can be anywhere from 1% to 8% of the total amount of the loan—which can really add up if you’re borrowing a lot.
Some credit cards offer a 0% annual percentage rate (APR) for the first year as a sign-up incentive. This can be used to your advantage if you are planning to have some big expenses that you are certain you could pay off over the course of a year.
Essentially, this is a zero-interest loan as long as you pay it off in 12 months. With a little pre-planning and a lot of repayment diligence, signing up for a new card with a no-interest promotion can help you save.
When is a Personal Loan a Good Option?
Since personal loans can take a little bit more paperwork and can come with an origination fee, they may be a more suitable option for when you need access to a larger amount of money—several thousand dollars or more. If you have expenses that you know will put you near the top of your credit card limit, for instance, a personal loan might be worth considering.
Personal loans also may be a more cost-effective option if you think it will take over a year to repay the amount you need to borrow. Lenders typically offer personal loans at a minimum of $1,000 and up to a maximum of $100,000 , depending on a borrower’s credit and financial profile.
Another benefit of a personal loan is the option for fixed terms. If you have concerns about over-spending on a credit card, a personal loan may offer you the structure of fixed limits. This can be particularly useful if you are borrowing money for a project in which there’s a risk of easy over-spending such as furnishing a new house or remodeling.
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FTC’s website on credit.