When an unexpected expense comes your way or you’ve been wanting to make a larger purchase, choosing between a personal loan or a credit card can be difficult. There are distinctions between the two, and knowing when to use your credit card or take out a personal loan can prevent financial hardship down the road.
If you need to take out a large lump sum of money for a project or want to pay off high-interest credit card debt, then you may want to consider a personal loan. If you’re making a smaller, everyday purchase, a credit card is the better option.
Here’s a look at the key differences between a personal loan and a credit card and how to determine which option is best for you.
Key differences between a personal loan and a credit card
A personal loan provides a lump-sum payment on which you make fixed, monthly payments until your balance is paid off. A personal loan is typically used for a larger expense or debt consolidation. A credit card is a revolving line of credit, meaning that you can repeatedly borrow funds up to a borrowing threshold – also known as a credit limit. Because of this, a credit card is typically best for ongoing daily purchases.
Here are some key differences you should be aware of when deciding which route to go:
|Credit Cards||Personal Loans|
|Repayment terms||Pay the minimum amount or the full accrued balance by the monthly due date||Make fixed monthly payments during a set period, typically between 12 and 60 months|
|Interest||Variable interest that accrues on unpaid balances||Fixed interest for the entirety of the loan|
|Funds disbursement||Revolving line of credit: You’ll have access up to your monthly credit limit||Lump sum: You’ll receive the full loan amount at once|
|Fees||Annual fees, late fees, over-limit fees, foreign transaction fees, etc.||Origination fees, prepayment fees, late fees, etc.|
When to use a personal loan
Taking out a personal loan makes the most sense when you know that you’re able to make the monthly payments for the full length of the loan.
Here are a few common reasons to take out a personal loan:
- Debt consolidation: If you’ve acquired large amounts of high-interest credit card debt, consolidating the debt into a single personal loan may give you a lower interest rate and more favorable repayment terms.
- Unexpected medical bills: A personal loan isn’t always recommended for paying off medical expenses. However, you may be offered lower rates and fees with a private lender than with your medical provider’s in-house financing options. Always consult with your medical provider to compare rates and fees before making the decision to use a personal loan to pay off medical debt.
- Home improvement projects: A personal loan could be beneficial if you’re planning on a home improvement project that will add value to your home. Plus, you don’t have to put up your home as collateral with an unsecured personal loan as you do with a HELOC or home equity loan.
- Finance a wedding: Weddings and other large events can be financed by a personal loan. Since the interest rates are lower than those of credit cards, you could save money in the long run.
Pros and cons of a personal loan
Knowing both the pros and cons of a personal loan can help you make a well-informed decision before taking out this form of financing.
- Versatility: Personal loans can be used for almost any reason.
- A good option for debt consolidation: Personal loan interest rates are often lower than those of credit cards, so they may be a good option to consider when paying down credit card debt.
- Reliable, monthly payments: The monthly payments are fixed, so you’ll be able to anticipate the amount and budget appropriately.
- Potentially high interest rates: If you have poor credit, you may get stuck with high rates and fees.
- Added debt: If you are unable to make the payments on time, interest and late fees will accrue, making the loan harder to pay off.
When to use a credit card
When it comes to credit card usage, paying off your balance in full at the end of the billing cycle is the most important thing you can do for your financial health. If you don’t pay your balance, the interest will accrue, meaning you may be paying off that purchase for a long time.
Because of this, you should only use your credit card for purchases that you’re certain you can pay off. Here are a few things that you should use your credit card on:
- Smaller, everyday purchases: A tank of gas or a cup or coffee are examples of purchases that are easier to pay off, helping you raise your credit score without putting you in deeper debt.
- A well-planned vacation: If you have a travel credit card, you may be able to earn enough points to score a flight or a hotel room, though this perk does take planning and well-managed credit usage.
- Cash back opportunities: If you have a cash back card with rotating categories (like one from Discover), taking advantage of the quarterly rotating categories can earn you some lucrative cash back bonuses.
Here are some examples of when using a credit card may not be the best option:
- Medical bills: If an unexpected medical expense comes your way, a personal loan may be a better idea. Personal loans tend to charge less interest than credit cards, which can prevent high-interest debt in the future.
- Large purchases: Any larger purchase that you don’t see yourself paying off by the end of the billing cycle is generally not a purchase you should be making on your credit card. Due to the interest accrual, you could end up paying off that purchase for a while.
- Loans: It’s not recommended to use your credit card for paying off loans, especially student loans. You could be left with a higher interest accrual, which means that you could be paying down that credit card debt for much longer than the loan.
Pros and cons of a credit card
When used responsibly, a credit card can be a great way to earn rewards, cash back and travel benefits. However, a credit card does have the potential to negatively impact your financial health.
Here are some pros and cons that you’ll want to be aware of when considering a credit card.
- Earn rewards and bonuses: Depending on the card, you can earn cash back bonuses and rewards on the purchases you’re already making.
- Long-term benefits: Your credit score will determine your creditworthiness, which can dictate your interest rates and whether or not you’ll get approved for a loan. Making timely payments on your credit card is a great way to boost your credit score.
- Convenience: Carrying around a credit card can be much more convenient than carrying cash. Plus, if something happens to your card or you misplace it, many issuers offer the option to temporarily freeze your account.
- High interest rates: Since your rates are usually based on your creditworthiness, if you have less-than-stellar credit, you could end up with a high interest rate.
- Potential for more debt: If not used properly, a credit card could leave you stuck with debt that is difficult to pay down. Failing to pay your credit card bill will also negatively impact your credit score.
- Associated fees: There are numerous fees that can come with a credit card. Make sure that you read the fine print of the specific card you’re considering.
Which is best for debt consolidation?
A personal loan is a useful tool for debt consolidation, especially for high-interest credit card debt. In fact, debt consolidation is one of the most common reasons people apply for a personal loan.
When you’re consolidating debt, the key is to find an interest rate lower than the one you’re currently paying. Otherwise, you’ll get stuck with more high-interest debt, making it even harder to pay off your balance.
Before you make the decision to consolidate your debt, evaluate your financial situation and spending habits to make sure you’ve got a solid plan in place to pay off the loan. A personal loan won’t do any good if you use it to pay off your credit cards but immediately begin racking up more debt.
Alternatives to a personal loan or a credit card
Personal loans and credit cards aren’t the only ways to access funds. Below are a few options to consider:
- Home equity loan: A home equity loan allows you to borrow a lump sum of money by using the equity you’ve established in your home over time. You can use a home equity loan for a number of reasons, including home improvement projects and debt consolidation.
- HELOC: A HELOC also uses the equity you’ve built up in your home to borrow funds, but it works more like a credit card. With a HELOC, you’re given a line of credit and can take out how much you need, when you need it. They are best for ongoing home improvement projects or expenses.
- Personal line of credit: A personal line of credit is a type of personal loan that functions like a credit card. You can draw from the loan as you need it, and you’ll pay the balance back with interest. Common uses of a personal line of credit include funding unexpected expenses and major purchases.
- Cash advance: A cash advance is an option provided by many credit card issuers that allows you to withdraw cash against your credit card limit. The interest rate charged for a cash advance is typically higher than the interest charged for purchases, so always check your lender’s rates and fees before withdrawing.
Featured image by Daniel Ingold/Cultura of Getty Images.