Key learning points
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Personal loans are best for large, one-time purchases or bills.
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Credit cards are best for everyday spending and reward systems.
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Both can have a positive impact on your credit score if used responsibly.
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Check the fees, rewards and repayment terms to compare these two financial instruments.
Knowing when to take out a personal loan or use your credit card can prevent financial problems down the road. They’re both useful ways to deal with an unexpected expense or a larger purchase, but there are some big differences in how you pay back what you borrow.
If you need to take out a large sum of money for a project or pay off high interest on your credit card debt, you may want to consider a personal loan. A credit card is the better option if you’re making a smaller, everyday purchase.
Personal loans vs. credit cards
A personal loan offers a fixed amount – minus any upfront costs, if applicable. You pay fixed monthly payments until your balance is paid off. Loans are typically used for major expenses or to consolidate debt.
A credit card is a revolving line of credit, meaning you can borrow money repeatedly up to a predetermined threshold, called your credit limit. That’s why a credit card is usually best for ongoing everyday purchases.
The main differences between personal loans and credit cards are the repayment terms, interest rates and how you access your money.
| Personal loans | Credit cards | |
|---|---|---|
| Average interest rates | 11.91% | 20.75% |
| Refund Terms | Make fixed monthly payments over a set period of time, usually between 12 and 84 months | Pay the minimum or full accrued balance by the monthly due date |
| Type of interest rates | Fixed interest on the entire loan | Variable interest accrues on unpaid balances |
| How money is spent | Lump sum: You receive the full loan amount in one go | Revolving credit line: you have access to your credit limit |
| Cost | Include origination fees, prepayment fees and late fees | Annual fees, late fees, over-limit fees, foreign transaction fees, and so on |
While there are many differences between a personal loan and a credit card to consider, there are also some important similarities. They are both a way to borrow money that you have to pay back on time. Consistently failing to do this could harm your ability to borrow more in the future, or even qualify for housing or jobs.
Personal loans
Personal loans typically have lower interest rates than credit cards and are aimed at large, one-time expenses.
Taking out a personal loan makes the most sense if you know that you can afford the monthly payments for the entire term of the loan.
Some common reasons for taking out a personal loan are:
- Consolidating debts with high interest rates.
- Paying unexpected medical bills.
- Completing home improvement projects.
- Cover wedding costs.
Unfortunately, there are times when the risk of using a personal loan can outweigh the potential benefits. Retail therapy, covering basic needs and expensive travel, are not advisable.
Advantages and disadvantages of a personal loan
Knowing the pros and cons of a personal loan can help you make an informed decision before using this form of financing.
Plus points
- Significantly lower average APR.
- Good for debt consolidation.
- Consistent monthly payments.
Cons
- No rewards, points or other benefits.
- Multiple charges.
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 a loan, a hard inquiry is placed on your credit report, which can temporarily drop your score by up to four points. It will remain on your credit report for up to two years, but will not affect your score after twelve months.
However, paying back your loan on time can improve your credit score, as payment history counts for 35 percent of your credit score. Using a personal loan to consolidate high-interest debt will also lower your credit utilization ratio — which makes up 30 percent of your credit score — and can improve your credit score in the long term.
Who is a personal loan 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 than your current debt, saving you hundreds of dollars or more.
A personal loan can also help pay for important expenses that cannot be saved on, such as home renovation or wedding costs. Using a personal loan instead of a credit card will likely incur less interest, so it can be helpful if you know exactly how much you need and don’t want to carry a balance on your card.
Credit cards
Credit cards have reward systems for frequent use, making them good for responsible everyday spending.
When it comes to credit card usage, paying off your balance in full at the end of the billing cycle is critical to your financial health. If you don’t pay off your balance and your card doesn’t have a 0 percent introductory period, interest will accrue, meaning you may have to pay off the balance for a long time.
Therefore, you should only use your credit card for purchases that you are sure you can pay off within a reasonable period of time.
Some ways you can use your credit card are:
- Make smaller everyday purchases.
- Paying for a well-planned vacation.
- Earn money back.
- Take advantage of a 0 percent interest option.
On the other hand, a credit card may not be the best idea for paying off loans, making large purchases, or paying for expensive unexpected bills such as medical expenses.
Advantages and disadvantages 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 can also have a negative impact on your financial health.
Plus points
- Earn rewards and bonuses.
- Increase your credit rating.
- Useful for daily expenses.
Cons
- High interest rates.
- Potential for overspending.
- Multiple associated costs.
How credit cards affect your credit
If you pay your credit card on time every month, you’ll build a history of on-time payments and can increase your credit score over time.
However, late payments that are 30 or more days past due can damage your credit. Additionally, carrying a high balance on your card can lead to a high credit utilization ratio, which will lower your credit score. It is usually a good idea to keep this ratio below 30 percent if possible.
Finally, if you have long-standing credit card lines that have been open for several years, this can boost your credit score. This is especially true if you have consistently maintained the accounts in good standing.
Personal loan and credit card alternatives
Personal loans and credit cards aren’t the only ways to access money. Home loans, lines of credit, and cash advances can also be useful ways to cover major expenses.
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Mortgage loan: With a mortgage loan you can borrow a lump sum by using the equity in your home. You can use a mortgage loan for a variety of reasons, including home improvement projects and debt consolidation.
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HELOC: A HELOC also taps into the equity in your home, but it works more like a credit card. With a HELOC, you get a line of credit and can withdraw how much you need when you need it. They are best for ongoing projects or home improvement expenses.
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Personal Line of Credit: A personal line of credit is a type of personal loan that functions like a credit card. You can withdraw the loan whenever you need it, and you pay back the balance with interest. Common uses of a personal line of credit include financing unexpected expenses and large purchases.
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Cash advances: A cash advance is an option offered by many credit card issuers that allows you to withdraw cash against your credit card limit. The interest charged on a cash advance is typically higher than the interest charged on purchases, so always check your lender’s rates and fees before withdrawing any money.
In short
While a credit card is good for getting rewarded for everyday purchases, it can lead to more debt if you go over your budget. It works the same way with a personal loan. Before you decide if a personal loan or credit card is right for you, research all your options and compare the rates and fees for each product by pre-qualifying.
And keep in mind that using both is an option. For example, you may decide that you want to take out a personal loan for a one-time purchase and apply for a credit card for regular expenses.
