Personal loans are sometimes overlooked by consumers considering borrowing options. Many borrowers first seek a credit card or line of credit for their immediate financing needs. However, a personal loan can sometimes be a better option than a credit card, offering advantages that a credit card can’t. The merits of a personal loan vary by situation, but they are a viable alternative to credit cards that can offer value and save money. Here are some of the advantages and disadvantages of personal loans, and when they may or may not be a better option than a credit card.
Advantages of Personal Loans
No collateral: Like credit cards, personal loans are unsecured loans, meaning that you are not required to put up an asset as collateral -- these loans are secured only by the borrower's promise to repay. With auto loans or mortgages, which are secured, the lender can repossess your vehicle or foreclose on your home should you miss your payments. Because personal loans are unsecured and represent more risk to lenders, interest rates are often higher than those of loans secured by assets. However, personal loan rates are generally lower than rates of credit cards.
Fixed interest rates and payments: Personal loans usually have fixed interest rates, though variable interest personal loans do exist. A fixed interest rate simplifies budgeting and provides stability with unchanging monthly payments. With credit cards, rates are variable, and the amount a borrower is charged for maintaining a balance tends to fluctuate over time.
Fixed term: Most personal loans have terms of two to five years. With a fixed-rate personal loan, the borrower knows exactly how much is due every month, and when the debt will be repaid. Additionally, more money cannot be borrowed without a new loan application. Credit cards can be used repeatedly up to their credit limit. The balance can be paid completely at the end of the month, or the borrower can carry a balance and make smaller payments over time. The risk with credit cards is that if borrowers are not careful and continuously carry balances, they can remain stuck in debt with no defined end date.
Does not affect credit utilization: Personal loans do not hurt credit utilization as most credit scoring models categorize personal loans as installment loans, not revolving credit. For example, if you needed $3,600 and decide to put the charge on a credit card with a $5,000 limit, you would have a utilization ratio of 72 percent (consumers with the best credit scores average about ten percent utilization or less). Taking out a personal loan would not do that. Credit utilization represents 30 percent of your FICO score and a high ratio can have a negative impact, especially if you carry the debt for a long period.
Disadvantages of Personal Loans
No rewards: Unlike credit cards, personal loans do not offer many of the bonus perks such as travel benefits, reward points, or cash back. Many credit cards also offer extended warranties or insurance on big ticket items such as appliances, furniture, or electronics. If upgrades, discounts, or insurance coverage are something that is a priority, a credit card may be a better option over a personal loan.
No introductory zero percent APR: Though personal loans can have lower interest rates than credit cards, they do not offer introductory borrowing rates. Borrowers with good credit who qualify can open credit cards offering zero percent introductory APRs. Many credit cards have these rates available for the first 9 to 18 months. As long as the loan is paid in full within the promotional period, the borrower can completely avoid interest. For small loan amounts or loans that can be repaid quickly, a credit card may beat a personal loan.
Applying for either a credit card or a personal loan can lower your credit score because each application triggers a hard inquiry on your credit report. Multiple hard inquiries within a short time may indicate unsustainable borrowing habits and can be a red flag to creditors. Before applying for a personal loan it is recommended you compare potential rates that lenders may offer by getting multiple quotes. It is also best to check your credit score before applying for any new loans or credit accounts. Consumers can check their credit score for free using LendingTree’s My LendingTree tool.