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When an unexpected expense comes your way or you’ve been wanting to make a larger purchase, choosing between a personal loan and a credit card can be difficult. There are distinctions between the two, and knowing when to take out a personal loan or use your credit card can prevent financial challenges.
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. A credit card is the better option if you’re making a smaller, everyday purchase.
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. Loans are 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 predetermined borrowing threshold 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.|
While there are many differences between a personal loan and a credit card to consider, there are also some important similarities.
“Both a credit card and a personal loan allow a consumer to conserve cash, purchase now and pay later,” says Jeff Arevalo, financial wellness expert for GreenPath Financial Wellness. “Both require on-time payments and responsible use so as not to negatively affect your credit or ability to secure funding in the future.”
Taking out a personal loan makes the most sense when you know you can make the monthly payments for the full length of the loan.
Here are a few common reasons to take out a personal loan:
- Consolidate high-interest debt
- Pay unexpected medical bills
- Complete home improvement projects
- Cover wedding costs
Unfortunately, there are times when using a personal loan may not be the most sensible idea:
- Finance unnecessary expenses
- Cover everyday expenses and basic needs
- Retail therapy
- Federal student loan payoff
Pros and cons of a personal loan
Knowing the pros and cons of a personal loan can help you make a well-informed decision before using this form of financing.
- A good option for debt consolidation
- Consistent monthly payments
- Potentially high interest rates
- Added debt
How personal loans affect your credit
Depending on how you use a personal loan, it can have a positive or negative impact on your credit score. When you apply for your loan, a hard inquiry will be placed on your credit report, which can temporarily decrease your score by up to four points. It will remain on your credit report for up to two years but won’t impact your score after 12 months.
However, if you pay your loan back on time, it could improve your credit score as payment history accounts for 35 percent of your credit score. Using a personal loan to consolidate high-interest debt will lower your credit utilization ratio — accounting for 30 percent of your credit score — which could improve your credit rating.
Before getting a personal loan, make sure you can pay it back on time. If you miss a payment, the lender may report it to one of the three major credit bureaus: Equifax, TransUnion or Experian. Because payment history accounts for 35 percent of your credit score, this can cause serious damage to your credit.
Who a personal loan is best for
If you have good to excellent credit and need to pay off a large expense or refinance high-interest debt, using a personal loan may be a wise financial choice. Using a personal loan instead of a credit card will likely involve less interest.
“Personal loans should be seen as a tool,” said Steve Sexton, CEO of Sexton Advisory Group. “A personal loan is for someone who needs a lump of money to pay off a debt that could be medical expense, credit card debt, or other loans. The personal loan strategy is designed to take pressure off the borrower when they have overspent. The best application will have a plan in place to pay off the debt.”
A personal loan works best if you can avoid late payment fees or damage to your credit score by making on-time monthly payments.
When it comes to credit card usage, paying your balance off 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 and your card doesn’t have a 0 percent introductory rate period, interest will accrue, meaning you may be paying that purchase off for a long time.
Because of this, you should only use your credit card for purchases you’re certain you can pay off.
Here are a few things you should use your credit card on:
- Make smaller everyday purchases
- Pay for a well-planned vacation
- Earn cash back
- Take advantage of 0 percent interest opportunity
When not to use a credit card
- Cover unexpected medical bills
- Make large purchases
- Pay off loans
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 you’ll want to be aware of when considering a credit card.
- Earn rewards and bonuses
- Boost your credit rating
- High interest rates
- Potential for more debt
- Associated fees
How credit cards affect your credit
If you pay your credit card off on time each month, you’ll build up a history of on-time payments and can increase your credit score over time.
However, late payments of 30 or more days past due can damage your credit. Also, keeping a high balance on your card can lead to a high credit utilization ratio, which lowers your credit score. It’s typically a good idea to keep this ratio below 30 percent — or 10 percent if possible. For example, if you have $20,000 of credit available, you should use less than $6,000 of it to maintain a good credit score. Keeping the balance under $2,000 is even better for your credit score
“If you utilize too much of your available credit, you will be viewed as highly dependent on credit and this will negatively impact your score,” says Adem Selita, CEO and co-founder of The Debt Relief Company. “However, the opposite is also true. If you have high credit limits and don’t often utilize the available credit, it’s a huge plus for your credit score.”
Finally, if you have long-established lines of credit cards that have been open for several years, this is viewed favorably by credit bureaus and can increase your credit score, particularly if you have consistently maintained the accounts in good standing.
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 your home’s equity, 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.
While a credit card is good for getting rewarded for making everyday purchases, it can lead to more debt if you buy things that don’t fit your budget. It works the same way with a personal loan. If you take out more than you can afford to, it can put you in a bad financial position.
Before you decide whether a personal loan or credit card is right for you, explore all of your options and compare the rates and fees for each product by getting prequalified. Also, consider whether it is a smart idea to get a credit card or personal loan before making a large purchase. For example, if you’re in the process of applying for a mortgage, taking out a large personal loan could impact your ability to qualify for the mortgage.
Ultimately, doing your research will help you determine which credit card or personal loan should work better for you.