Credit cards are a tremendous convenience–and an expensive one if you carry a balance. If you’re anticipating a large purchase, or currently carrying a balance you can’t clear within months, there may be a more cost-effective alternative.
- Personal loan interest rates are lower
- Personal loan interest rates and payments are usually fixed
- Personal loans don’t increase credit utilization and harm your credit
Personal loans generally offer lower interest rates than those that credit cards charge. That has never been more true than at the present time. The past couple years have seen personal loans widen their cost advantage over credit cards to a record level.
The growing advantage of personal loans vs. credit cards
We use credit cards more frequently than personal loans because of convenience on the front end and flexibility on the back end.
On the front end, having a credit card in your wallet gives access to credit whenever you need it. No additional applications, and no delays. On the back end, credit cards give you flexibility as to how quickly you repay your debt. There is no set payment schedule, aside from minimum payments. You can pay more in months when you have extra cash available, and less in months when money is tight.
That convenience and flexibility comes at a price. Credit cards are generally more expensive than personal loans. How much more expensive? Well, Federal Reserve data on personal loan and credit card interest rates shows credit card rates averaged 14.23 percent compared to 11.87 percent for personal loan rates, from 1994 to 2019. That’s a 2.36 percent advantage for personal loan rates, meaning personal loans have cost borrowers $236 less per year for every $10,000 of debt.
The gap between personal loan rates and credit card rates has fluctuated over time. It has even dropped below 1 percent now and then. However, the most recent report from the Fed shows personal loan interest averaging 10.7 percent, while credit card interest averages 16.86 percent–a difference of 6.16 percent.
The resulting 6.16 percent interest rate difference means that credit card borrowers now pay an average of $616 a year more for every $10,000 of credit card debt than they might for personal loan debt.
Credit card vs. personal loan payments
Credit cards do give you more flexibility with payments because you can make a minimum payment when finances are tight. The payment for a 10.7 percent personal loan over 24 months with a $5,000 balance would be $232.34, and you’d pay $576.24 in interest.
A credit card for the same balance at 16.86 percent would have a minimum payment of $100. However, if you only pay $100 a month, it will take you 86.89 months to repay it. And the interest cost would be $3,689!
One strategy you might consider for a large purchase is to use a card with a zero-interest introductory rate for 18 months. Then pay off any remaining balance with a personal loan. If you have a rewards card, you may want to adopt a similar strategy by paying with the card, then repaying the card balance with a personal loan.
When are personal loans better than credit cards?
Personal loans are generally cheaper than credit cards, but less accessible for everyday use. So, when should you consider a personal loan? Here are three instances when a personal loan might work better than a credit card:
- You are planning a large purchase. You aren’t going to go to the trouble of taking out a personal loan for every couple hundred bucks you spend here and there. But when a purchase gets into the thousands of dollars, the savings might make it worth your time applying for a personal loan rather than just reaching for your credit card.
- You need to consolidate debt. If you have built up a sizable credit card balance, it may be wise to take out a personal loan to pay off that balance if you can get a cheaper interest rate in the process. However, this should only be done if you have a plan for paying down debt from that point forward. Debt consolidation should be an alternative to credit card debt, not simply a means of taking on additional debt.
- You need fixed payments. Unlike a credit card, a personal loan gives you a schedule of regular payments that you must meet. This can make budgeting easier, but the payment usually is higher than the minimum required on credit cards. Don’t take out a personal loan unless you think you will have the income available to meet those payments.
Things to do before taking out a personal loan
If your situation meets the conditions described above, then a personal loan may be a better alternative than credit card debt. If so, here are four things to do before taking out a personal loan:
- Check your credit report. Assess whether you are likely to qualify for a personal loan, and whether there are any issues you should address before you apply.
- Think ahead. If you have other major expenses coming up in the next couple years, think carefully before taking on new debt now, or apply for a loan amount that covers immediate and upcoming needs.
- Budget your payments. Before you sign up for the loan, review the payment schedule. Develop a household budget for meeting those payments while taking into account your other expenses and obligations.
- Shop for the best loan rates. While personal loan rates generally offer an advantage over credit card rates, loan rates from different lenders can vary greatly. Shop around to maximize your interest rate savings.
The goal with debt should be to get it paid off within a reasonable time period. Lowering the cost of your debt with a personal loan may help you meet that goal.