What are the main differences between personal loans and credit cards?
For a lot of people, using credit cards is the go-to method to build their credit history or 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 expenses. Plus, many cards offer rewards and perks. As long as the borrower is able to pay the balance in full each month to avoid paying high interest rates, credit cards can be convenient.
Personal loans can be another option for acquiring cash up front for big purchases that a person may not have the cash on hand to pay for. Personal loans are closed-end installment loans, versus the revolving, open-end nature of credit card debt, and repaying them is a different process.
Here’s a closer look at personal loans and credit cards.
Personal Loans, Defined
Personal loans are, generally, unsecured loans that can be used for nearly any purpose. The borrower receives the loan amount in a lump sum and is then required to make fixed monthly payments, typically for a term of two to five years — sometimes longer.
Whatever length the loan term is, the borrower makes regular monthly payments on the loan with the intent of paying it off by the end of the loan term. However, the balance may be paid off early, hopefully without paying a penalty. It’s a good idea to check with the lender to make sure the loan doesn’t have a prepayment penalty.
Unsecured personal loans often offer fixed interest rates over the life of the loan. Variable rate personal loans are also an option, their interest rates changing based on market fluctuations. People paying off a personal loan over a longer term may not want to risk a variable rate loan because it’s hard to predict whether or not the interest rate will rise.
Reputable lenders can be found online or in person. The applicant will likely have to provide personal and employment information, possibly including proof of income such as a Form W-2 from an employer, among other requirements that will vary from lender to lender.
After the application is complete, the lender reviews the application and decides whether or not to grant the loan.
If the applicant is approved and agrees to the terms of the loan, they may sign a promissory note, and receive the lump sum loan amount. After that point, they’ll be required to make payments on the loan.
Recommended: Secured vs. Unsecured Loans: How Do They Differ?
Key Differences: Credit Card vs Personal Loan
While both credit cards and personal loans offer a borrower access to funds that they promise to pay back later, there are some key differences that may have major financial ramifications for borrowers down the line.
A borrower requests a set amount of money with an unsecured personal loan, and chooses a set term to pay it back, whereas a credit card gives borrowers access to a line of credit that can be borrowed from as needed (up to the credit limit). This may seem like a positive, flexible benefit, but it can lead to a debt spiral if not managed responsibly.
Credit card debt is revolving debt, meaning the borrower can continuously borrow up to their credit limit without paying the full balance back before borrowing again. When carrying a balance on a credit card each month, a borrower could become stuck paying a high interest rate on the revolving debt.
Personal loans, on the other hand, offer the borrower a lump sum amount and they agree to make regular installment payments of the same amount each month over a set period of time. That means the borrower knows exactly how much they owe — both on a monthly basis and in total—when the loan is signed. The loan principal can’t be increased by swiping a card; a second loan would need to be taken out to have additional funds. For this reason, a personal loan debt may be easier to manage than credit card debt for some people.
One of the ways in which personal loans and credit cards are similar is that both financing options are actually unsecured, and as such tend to come with higher interest rates than secured loans, like a HELOC.
Like mortgages, home equity lines of credit (HELOC), or auto loans, secured personal loans tend to have a lower interest rate because they’re tied to an asset that the lender can repossess should the borrower be unable to repay the loan. Still, depending on their financial profile, a prospective borrower may be able to find an unsecured personal loan with a lower interest rate than a credit card.
Line of Credit vs Loan
There are also differences between a line of credit and a loan.
A line of credit is an ongoing agreement with a bank allowing a borrower to access funds up to a certain dollar limit at any time during a draw period. A personal line of credit is similar to a credit card, though it’s usually not attached to a little piece of plastic. The borrower can use the funds, repay the amount used, and then borrow them again. Typically, the borrower writes checks directly from the line of credit or has the funds transferred to another account, rather than swiping a card.
This differs from a loan in both amount borrowed and the loan term. While funds accessible via a line of credit can essentially be borrowed up to the credit limit, paid down, and borrowed again back up to the credit limit, the funds available through a loan are only available one time, as a lump sum. The term of a personal loan is also different from that of a line of credit in that it has a definite end date. The term of a personal line of credit is open-ended, but can be closed by the lender or at the request of the borrower.
Consolidating Debt? Personal Loan vs Credit Card
Although it may seem counterintuitive to take on additional debt when already contending with existing debt, sometimes it can actually be a smart money move. Debt consolidation is a common reason borrowers take out personal loans, and it’s also possible to consolidate debt with a credit card balance transfer.
Again, these two approaches have some basic commonalities, but work pretty differently when looked at closely — and those differences can have a major impact on a person’s financial wellness over time.
Using a Credit Card to Consolidate Debt
Credit card refinancing generally works by opening a new credit card with a high enough limit to cover whatever balance you already have. Some credit cards offer a 0% interest rate on a temporary, promotional basis — perhaps for the first year or two of holding the card.
This can be a great opportunity to save money on interest by paying off the debt before the promotional time period ends. However, if the balance is not paid in full before the promotional period ends, the borrower will be charged the card’s set interest rate for regular purchases, which is currently averaging more than 16% APR, on any remaining balance.
Additionally, these types of balance transfers often come with an associated balance transfer fee that could be up to 5% of the total being transferred, which could lower the total potential savings.
Using a Personal Loan to Consolidate Debt
Taking out a debt consolidation loan works a little differently. A loan is taken out for an amount that will cover the borrower’s existing debts, likely simplifying their repayment strategy (repaying just one debt instead of multiple credit card balances) while also potentially costing less in interest, depending on the borrower’s existing credit card rates and the rate of the new loan.
When consolidating debt with a fixed-rate personal loan, the borrower will know exactly how much they’ll owe each month, which can make it much easier to keep up with their monthly payments. Instead of keeping track of multiple due dates, multiple monthly amounts due, and multiple total balances due, there is just one monthly due date, one fixed monthly payment, and one total balance to keep track of.
Both of these approaches have benefits and drawbacks, though credit cards can be riskier than personal loans over the long term — even when they have a 0% promotional interest rate.
Recommended: See how much extra you may be paying with our Credit Card Interest Rate Calculator
Is a Credit Card Ever a Good Option?
If someone only needs access to a few hundred or a few thousand dollars, and if they plan to be able to pay down the balance of the debt completely over the course of just a few months, a credit card might be a good choice.
Personal loans may charge 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 with large amounts borrowed.
In the end, it comes down to a borrower’s personal preferences and diligence. So long as a credit card is used responsibly — paying the balance off in full each and every month — credit cards are a common way to build credit history and have a resource for funds should an urgent need arise (plus, some like that they can get perks like cash-back rewards, too).
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When is a Personal Loan a Good Option?
Since personal loans can take a little bit more paperwork and sometimes include an origination fee, they may be a more suitable option for when a borrower needs access to a larger amount of money — several thousand dollars or more. If expenses will put the borrower near the top of their credit card limit, for instance, a personal loan might be worth considering.
Personal loans also may be a more cost-effective option if it will take over a year to repay the amount needed 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 fixed terms. When there are concerns about over-spending on a credit card, a personal loan may offer the structure of fixed limits, both on the amount borrowed and repayment time. This can be particularly useful when borrowing money for a project in which there’s a risk of easy over-spending such as furnishing a new house or remodeling.
The Takeaway
Different options work for different people and different financial situations. When deciding whether to use a credit card or personal loan, learning the differences between the two is a good place to start.
SoFi Personal Loans are unsecured, have no fees required, and offer fixed rates with terms to fit a variety of budgets.
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