If cash isn’t an option, personal loans can be a low-cost way to finance a purchase or consolidate debt.
Overlooked in the past, they’re growing in popularity as consumers realize the benefits of personal loans. They tend to be cheaper than credit cards. Thanks to digital platforms, applying is quick and easy.
Personal loan vs credit card: what’s the difference?
The big difference between a personal loan and credit card is how you receive and pay back the money. With a personal loan, you’re given a lump sum and a payment schedule. Interest is typically fixed throughout the life of the loan.
Credit cards give you access to credit and flexible repayment terms. You won’t have to pay the balance off in any time frame. This convenience can be dangerous, because it’s easy to make the minimum payment and carry expensive balances.
Deciding between when you should choose a personal loan or when you should use a credit card can be confusing. Before you choose, you need to weigh the pros and cons of both. Here’s a guide to get you going.
Personal Loan Pros
Personal loans offer a few advantages over credit cards, especially for larger purchases.
- They’re cheaper: For most, the interest rate is lower at any credit score. Your credit score determines your interest rate, whether for a personal loan or credit card. The higher your credit score, the cheaper the debt. On average, interest rates for credit cards run about 7% higher than rates for personal loans (as of this writing).
- There’s an end: Credit card debt can be crushing. Many credit card issuers set the minimum payment so low that paying off the debt can take decades. And many consumers get caught in a cycle of carrying balances. A personal loan is finite. It has an ending. When the term is up, the loan is paid.
- Improves your credit: A personal loan can help you establish good payment habits and a good credit score. The fixed rate and payment make repayment and budgeting easier. And replacing credit cards debt with a personal loan can increase your credit score. That’s because zeroing your credit card balances lowers your credit utilization ratio — a number that comprises 30% of your credit score.
Personal loan cons
- It’s not free: Nothing in life is free and that is true of a personal loan. In addition to the interest, lenders charge fees — typically 1% to 8% of the loan amount. (The fee percentage usually decreases as the loan amount increases.)
- Lower credit score borrowers pay more: Just like credit card issuers, lenders put borrowers through the paces when underwriting loans. If you have a poor credit score, the rate you pay may be higher.
- Its still debt: Personal loans can help you manage your debt, but they don’t address why you may have accumulated debt in the first place.
Pros of credit cards
- Builds credit: In order to borrow money, you need to prove you’re a worthy borrower that can pay back debts. One way to build credit is through a credit card.
- Rewards and perks: The credit card industry is competitive with issuers dangling cash back rewards, travel bonuses and other perks to get you on board. There’s a catch: you have to spend money on the cards to earn those rewards.
- Introductory interest rates: If you have good credit, you may be able to put a large purchase on a new card with a 0% interest rate and pay no interest for up to 18 months. Just make sure you repay the balance before the introductory periods ends.
Cons of credit cards
- High interest rates: Credit card companies tend to charge higher interest rates than personal loan rivals. As of this writing, the average credit card interest rate was about 17%, while the average personal loan rate was just over 10%.
- Spurs a cycle of debt: Credit cards make it easy to purchase items you can’t afford. But spending more than you earn is unsustainable. The last thing you want to do is pay the minimum on high interest credit cards indefinitely.
Personal loan vs credit card
When should you use a personal loan? When should you use a credit card?
The decision comes down to the purchase size if the interest rate and fees are similar. If it’s an expensive item that will take a long time to pay off, a personal loan is the better option. If it’s a small purchase you can afford to pay back at the end of the month, a credit card wins out.
If you have a zero-interest card, you’ll definitely pay less interest than you would with a personal loan — as long as you repay the balance before the real interest rate kicks in.
For all but the smallest purchases, a personal loan tends to be the better choice. You get to finance the purchase at a fixed interest rate and you clear the debt when you zero your balance. However, there is no reason to forgo the miles, rewards or cash back that come with your credit card. Put the large charge on your card, and pay it off with a personal loan at a better rate.