Personal Loans vs. Credit Cards: Which Is the Best Choice?
If you’re paying off high-interest debt, borrowing money, shelling out funds for an unplanned expense or you’re just short on cash, you may be considering applying for a personal loan or charging the expense to a credit card. Not knowing the pros and cons of each option could make your choice difficult.
Here’s what to consider as you compare personal loans and credit cards.
Comparing personal loans to credit cards
Often, the choice to use a credit card or personal loan will depend on your situation, credit score, how fast you want to pay off the debt and how much you need to borrow.
Personal loans offer a fixed interest rate and payment term. This means that the amount you pay each month will not change, and you will have a set window of time in which you will pay off your debt before you incur late fee or penalties.
Credit cards must be paid back in monthly installments or one flat payment. If you can’t pay off your balance, you will be charged interest on whatever balance you carry over. Keep in mind that paying off the full statement balance by the due date not only helps you avoid interest and fees, but may also help you establish a positive credit history.
But if you use a card with a 0% intro APR offer, it may make sense to pay only the minimum payment. In this case, it is still important to make at least the minimum payment due each month, with no late or missed payments. Make sure to pay off the whole balance before the introductory period ends, or you’ll be stuck with credit card debt that’s accumulating interest.
To help you decide between these two forms of credit, consider the following pros and cons.
Personal loans: A deep dive
A personal loan is considered an installment loan. This type of loan is repaid over a set period. When you apply for a personal loan, you may need to disclose how you will use the funds. You can use a personal loan for many expenses, including but not limited to:
- Debt consolidation
- Medical bills
- Home renovations
- Car repairs
- A wedding
Personal loans are either secured by a co-signer or by the asset purchased, or unsecured. Unsecured loans are granted based on a borrower’s credit history and ability to repay the loan. Repayment is typically through fixed installments over a set term.
The interest rate you pay on a personal loan may depend on whether you have collateral, how high your credit score is and the length of your term, among other factors. The cost of the loan will be spread out over multiple payments. Typically, the longer the loan term, the higher the interest rate Although the interest rate on your loan will depend on many factors. As of publication, typical APRs for personal loans are as low as 3.99%, according to the personal loan marketplace on MagnifyMoney, a LendingTree company.
|Pros and Cons of a Personal Loan|
|Pros of Personal Loan||Cons of Personal LOan|
|You can qualify to borrow large sums
You may get fixed interest rates with set repayment terms
The loans can be repaid over extended periods
|You may be required to put up collateral
High interest rates are possible
You may need to pay loan origination fees
These can be hard to qualify for
When a personal loan beats a credit card
A report from Pew Charitable Trust outlines that over the past 30 years, families in the U.S. have taken on increasing amounts of debt, with 80% holding some form of debt. This can either signal economic opportunity or potential trouble, encourage wealth-building or increase financial insecurity.
There are times when a personal loan can come in handy, as well as times when a personal loan, hands down, surpasses a credit card. Personal loans don’t allow you to borrow money over and over again, so you may not be able to overextend your budget.
Also, you know exactly when your loan will be paid off, allowing you to plan ahead and set goals. Because personal loans allow you to pay off the amount borrowed over a set period by making scheduled payments, you can build good credit and boost your credit score.
Personal loans typically cost less than using credit cards. The same may be true if you are trying to consolidate debt. With a credit card, you may be charged a balance transfer fee to move your debt from one card to another. With a personal loan, on the other hand, you will get your loan funds and use them to pay off your debt.
Another advantage is that moving your credit card balance to a personal loan may help reduce your credit utilization ratio, which is factored in your credit score. Your credit utilization ratio shows how much of your available credit you are using. For example, if you have a total of $5,000 in credit available to you on a credit card, and you’re carrying a $2,500 balance, your credit utilization ratio is 50%.
With a personal loan, many lenders can have a decision if you’re approved within a few hours, and the money can be in your bank account within a few days.
Credit cards: A deep dive
Credit cards are a form of revolving debt. A revolving line of credit, such as a credit card, gives you open access to a certain amount of money. For example, if you have a credit card with a $10,000 credit limit, you can go to any store and rack up charges up to that amount. (This is not advisable, of course). As you pay down your debt, you can make new charges on your card up to your credit limit.
But any credit card debt you carry from one month to the next will be charged interest. This interest is the price you pay for borrowing money and making purchases on your credit card. Interest rates vary for several reasons. With a fixed-rate credit card, your rate will remain the same as long as you keep your account in good standing. With a variable-rate credit card, your interest rate will fluctuate with market changes.
Traditionally, credit cards have had high interest rates. Current APRs are up to 28% on MagnifyMoney’s list of low-interest credit cards. But other credit cards may fall outside those limits.
One notable benefit to credit cards is rewards programs. Rewards credit cards may offer you cash back or points you can use on merchandise, travel, gas or other perks. But rewards credit cards typically come with higher interest rates and can be harder to qualify for.
|Pros and Cons of a Credit Card|
|Pros of credit cards||Cons of credit cards|
|Funds are available when you need them
You can borrow from your existing line of credit without going through the approval process
You can earn rewards as you spend
|They almost always come with variable interest rates
They often carry higher interest rates
They may have commitment fees
You may not be able to borrow large amounts at once
When a credit card beats a personal loan
When refinancing high-interest debt with a credit card or when determining whether to use a personal loan versus a credit card, the purpose and the situation should be the determining factor.
With a credit card, you use available credit as needed and pay interest only on the amount carried from month to month. Thus, a credit card could be a good resource for emergency funds if you don’t have the time to apply for a personal loan and wait for funds to be disbursed, and if you only need to borrow a small amount of money.
Although the interest rate on credit cards may be higher than on personal loans, you can find credit cards offering a 0% promotional APR for a specific period. This kind of promotion would allow you to carry a balance month to month without paying interest. Depending on the card, a 0% interest rate can last up to 21 months. This kind of deal could make it more worthwhile to consolidate debt with a credit card rather than via a personal loan, assuming you can pay off the balance in full before the promotional period ends.
As great as that sounds, credit cards do come with a certain amount of risk. If you’re one day late with a payment, you risk the credit card company canceling your 0% APR offer. Plus, you may be charged late fees, and your credit score can take a hit. If you think you may forget a payment along the way, set up autopay to ensure that never happens.
Alternatives to credit cards and personal loans
Home equity loan
A home equity loan uses your home’s equity as collateral. Equity is the difference between your home’s appraised value and the balance left on your mortgage. For example, assume the appraised value of your home is $250,000 and the balance owed on your mortgage is $150,000. You would have $100,000 in equity.
A home equity loan usually has a fixed interest rate and set repayment period. Because your home is secured by the loan, it may be easier to obtain a loan even if you have bad credit. But if you fail to make monthly payments, the bank could foreclose on your home. If you itemize deductions on your tax return, the interest charged on your home equity loan could be tax deductible. If you use the funds for substantial improvements on your home, you may qualify.
Keep in mind that home equity loans have closing costs and other fees. You may be saving on interest, but the upfront cost you pay to take out the loan may be higher than a line of credit.
Home equity line of credit
A HELOC, or home equity line of credit, is a line of credit to be drawn on when you need the money rather than taken in one lump sum like with a home equity loan.
In many ways, a HELOC is similar to a credit card in that you are given a specific credit limit from which you can borrow. During the draw period, typically 10 years, you can draw on your HELOC and pay back only what you use, plus interest.
HELOCs are convenient for funding intermittent needs, such as paying off high-interest credit card debt, paying for a wedding or buying a car. Upfront costs are relatively low, and you draw and pay interest only on what you need. But you may incur refinance fees.
Because it also resembles a second mortgage, some people think of a HELOC as a mortgage loan. Whereas a mortgage is solely used to fund the purchase of a home, a HELOC is a revolving line of credit that uses your home as collateral to secure the money you borrow.
A cash-out refinance is another way to consolidate debt. It replaces your existing mortgage with a larger loan amount. You then receive the difference in cash.
Because a home is typically a borrower’s biggest asset, it can be used to get the cash you need when you need it, and often at a lower interest rate. Again, there are pros and cons to borrowing money against your home, and you need to understand the risks.
When you borrow money for house repairs, for instance, it will be less expensive to take out a cash-out refinance compared to putting the charges on a credit card. But by doing so, you are typically extending your mortgage terms.
As with a home equity loan, if you lose your job or become unable to make payments, your home could end up in foreclosure. By having a higher mortgage balance, you also risk the chance of paying more than the value of your home should property values fall. There are also fees on cash-out refinance loans.
By the way, you can use the funds any way you wish, and the interest you pay may be tax deductible.
Tapping into retirement funds, your individual retirement account (IRA) or a savings account can be tempting, but whether it’s a good idea is up for debate.
When you draw funds early from an IRA, you may face penalties and taxes, which can be pricey. A Roth IRA, however, lets you withdraw money tax-free, assuming it’s been in your account for more than five years and you’re older than 59½. If you draw funds from a traditional IRA and are older than 59½, you will pay taxes on the money you withdraw.
By withdrawing money from a retirement account, you jeopardize losing the money you worked so hard to save for your future retirement. By withdrawing money from your savings account, you risk not having the funds available if an emergency crops up.
Borrowing from friends and family
If you are responsible with money and have friends or family willing to lend you funds, this could be one way to get the money you need to cover expenses without paying interest. It could also allow you to access funds when you may not qualify for credit.
But it’s important that you communicate with the individual who is lending you funds. Make a plan that everyone can agree on and stick by it. Failing to repay your debt could strain your personal relationship.
So which is right for you: A personal loan or credit card?
Both options – personal loan or a credit card – have advantages and disadvantages. Personal loans may be best for people who need to borrow more, such as to consolidate credit card debt, and want fixed monthly payments. Credit cards are best for people who want open access to funds to cover periodic expenses and who may be able to make a purchase they can repay over a promotional no-interest period.
Revolving credit can weigh heavily on your credit score if you maintain a high credit utilization ratio. On the other hand, the approval process for a personal loan may be too slow if an unexpected expense comes up and you need to pay for it now.
Consider your needs as you weigh your options. If you decide a personal loan is right for you, consider shopping rates on LendingTree. You can also explore credit card offers. For example, LendingTree lists balance transfer credit cards you can compare if you’re looking to consolidate debt.