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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, among others||Origination fees, prepayment fees, late fees, among others|
While there are many differences between a personal loan and a credit card to consider, there are also some important similarities. They’re means of borrowing money that you must pay back in a timely manner. Consistently failing to do so can damage your ability to borrow more in the future, or even qualify for housing or jobs.
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 the risk of using a personal loan could outweigh the potential benefits. Retail therapy, covering basic needs and paying off loans with protections — like federal student loans — is not advisable.
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.
Who a personal loan is best for
If you have good to excellent credit and need to refinance high-interest debt, using a personal loan may be a wise financial choice. It allows for consistent payments, and may be available at a lower interest rate.
A personal loan can also help pay for an important expense that can’t be saved up for. Using a personal loan instead of a credit card will likely involve less interest.
When it comes to credit card usage, paying your balance off in full at the end of the billing cycle is critical 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 the balance off for a long time.
Because of this, you should only use your credit card for purchases you’re certain you can pay off in a reasonable amount of time.
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.
On the other hand, a credit card may not be the best idea for paying off loans, making large purchases or covering expensive unexpected bills, such as medical costs.
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 overspending.
- 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 if possible.
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. 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.