When paying cash isn't an option, personal loans and credit cards are popular ways to make purchases. But one is usually better than the other, depending on the circumstances. Here's what to look for when choosing personal loans vs credit cards.
Personal Loans vs Credit Cards: Big Differences
The most profound difference between personal loans and credit cards is the way you access and repay the money.
With a personal loan, you normally get a fixed interest rate and make equal monthly payments. When you take out a personal loan, the lender delivers a lump sum and a payment schedule. This is called "closed-end credit."
With a credit card, you receive the right to borrow up to a predetermined limit whenever you wish. Your interest rate is almost always variable. You can use and reuse your credit line as long as you make a minimum payment on time. This is called "open-ended credit."
Deciding between when to use a personal loan or a credit card can be confusing. This guide can help you make the right decision and save you hundreds or thousands of dollars.
Personal Loan Pros
Personal loans offer a few advantages over credit cards.
Personal loans are cheaper
Personal loan interest rates are nearly always lower than credit card interest rates. Even though both loans are unsecured, personal loan vendors get a lot more verified information about their borrowers than credit card issuers do. That translates to less risk for them and lower rates for you.
On average, interest rates for credit cards run about 6% - 7% higher than rates for personal loans (as of this writing). And while personal loans can have loan fees (not all do), you only pay them once. Credit cards with annual fees make you pay every year, even if you don't use them.
Personal loans are not forever
Credit card debt can sneak up on you. Many credit card issuers set the minimum payment so low that paying off the debt can take decades unless you make a conscious decision to accelerate repayment. Many consumers get caught in a cycle of carrying balances. A personal loan is finite. You pay it off and you're done with debt.
Personal loans can improve your credit score
A personal loan can help you establish good payment habits and a good credit history. The fixed rate and payment make repayment and budgeting easier. And replacing credit card 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
Of course, personal loans have their drawbacks as well.
There may be fees
Depending on the lender and loan amount, a personal loan can cost up to 8% to originate. Higher percentages usually go with smaller loan amounts. The typical loan fee is about 3% but some lenders don't charge origination fees at all.
Your payments may be higher
Personal loan terms run from 12 months to 12 years, but most lenders max out at five-year terms. This means your payment will probably be higher than a credit card minimum even if your interest rate is lower. For instance, a $5,000 credit card balance may have an interest rate of 17% and a minimum payment of $100. A $5,000 three-year personal loan at 10% has a payment of $161.
Credit Card Pros
Credit cards have their place in your financial arsenal if managed well. Here are their strengths.
Credit cards are easier to get
Credit cards are easier than personal loans to get if you're just starting out. There are secured credit cards, store credit cards and credit-building cards to help build or rebuild credit. They usually have low credit limits and higher interest rates, but if you pay them in full each month, the interest rate doesn't matter.
Credit cards may offer rewards
The credit card industry is highly competitive. That's good because you can choose the reward or promotion that works best for you - an interest-free period, travel miles or merchandise.
If you have good-to-excellent credit, you may be able to put a large purchase on a new card with a 0% interest rate. Or transfer other account balances and pay no interest for up to 18 months.
Credit cards are flexible
It's easy to make purchases and pay bills with credit cards. You can shop safely online, reserve hotel and rental cars, pay bills and arrange car rides using just an account number and verification code.
Credit Card Cons
Credit cards also have disadvantages. They are not all things to all consumers.
Credit cards have higher interest rates
Credit card issuers tend to charge higher interest rates than personal loan providers. As of this writing, the average credit card interest rate is just under 17%, while the average personal loan rate is just over 10%.
Credit card debt can sneak up on you
Credit cards make unwise purchases easy. Studies have shown that consumers spend a lot more carefully when they have to take cash out of their wallets than they do when swiping or hitting "Buy It Now." And the low minimum payments can establish a habit of carrying expensive balances instead of paying them off.
Personal Loan vs Credit Card for Large Purchases
When should you use a personal loan? When should you use a credit card?
We use credit cards more frequently than personal loans because of convenience on the front end and flexibility on the back end. With credit cards, you get access to credit whenever you need it. No additional applications, and no delays. And repayment is flexible. You can pay more in months when you have extra cash available, and less when money is tight.
That convenience and flexibility comes at a price. The most recent report from the Federal Reserve shows personal loan interest averaging 10.7%, while credit card interest averages 16.86% - a 6.16% difference.
That 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 balances.
Credit Card vs Personal Loan Payments
Credit cards offer more flexibility because you can pay the minimum when finances are tight. The payment for a 10.7 percent personal loan over 24 months with a $10,000 balance would be $464.48, and you'd pay $1,152.48 in interest.
A credit card for the same balance at 16.86 percent will likely have a $200 minimum payment. However, if you only pay $200 a month, it will take you 86.89 months (over seven years) to repay it. And the interest cost would be $7,378!
Large Purchases: Work the System
Credit cards are great for purchasing but often terrible for borrowing. But you can get the best of both worlds by charging your large purchase first. If you have a rewards card, you get your points, cash back or other benefit. If you have a zero-interest introductory rate, use it.
Then pay the balance with a personal loan (before the introductory rate expires if using a zero-interest credit card). This gets you a lower rate, less interest expense and a definite end to your repayment.
Personal Loans vs Balance Transfer Cards for Debt Consolidation
If you're trying to consolidate and pay off debt faster, you have two popular options - a balance transfer credit card and a personal loan. Both solutions:
- Can reduce your interest rate
- May speed up debt repayment
- Have costs and pitfalls
Examine the pros and cons of personal loans vs. balance transfers. Before deciding, consider your own strengths and weaknesses.
Personal Loans for Debt Consolidation
As noted above, personal loans have a few advantages for debt consolidation - among them, lower interest rates and fixed payments.
However, if your credit rating has suffered since getting your credit cards, you may not be able to obtain a lower interest rate. And even if your interest rate drops, your monthly payment is likely to increase. Of course, that's part of bringing about an end to your debt - you may have to buckle down and pay more each month. Finally, most personal loans have origination charges - 3% is about average.
If you can't afford the monthly payment, a personal loan won't help you consolidate debt. The viability of personal loans as an option depends on the interest rate you get. So it pays to shop aggressively with more than one provider. You might be able to make repayment affordable with a longer term. Some lenders allow up to 12 years for larger amounts.
Consolidating Debt with a Balance Transfer
Balance transfer credit cards allow you to move your debt from higher-interest accounts to an interest-free account. The introductory rate can be good for up to 18 months. The longer the interest-free period, the better.
This gives you the chance to pay down credit card balances faster. Every dollar goes to debt reduction instead of interest.
An interest-free period can save you a lot of money. If you have $5,000 in debt on a card with a 19% interest rate, and you paid $200 a month, in 18 months you'd have paid $1,106 in interest and you'd still owe $2,506. While with a balance transfer card, you'd have paid no interest and your balance would be just $1,400.
But the biggest pitfall is that some cards have "deferred" interest. That means if you don't clear the entire balance before the regular interest rate kicks in, the card issuer applies that new rate - retroactively - to your entire balance transferred. That can get very expensive
In addition, balance transfers are open-ended and there is nothing to force you to pay off your debts completely. If you choose a balance transfer card, know exactly when you must pay off the balance to avoid interest charges. And make sure that you can afford the payment that will clear your balance in time.
Combining Balance Transfer Cards and Personal Loans
Personal loan interest rates are greater than zero. So if you can pay off your entire balance within the zero-interest period, the card is obviously the way to go.
If your debts exceed what you can repay with a balance transfer credit card, try combining the card and a personal loan. First, apply for personal loan approval so that you know what rate and terms you can expect. Then apply for your balance transfer credit card.
If you have $10,000 to repay and can devote $250 a month toward repayment, it might look like this:
- Get preapproved for a personal loan with a 10% interest rate.
- Transfer your balance to an 18-month zero interest card with a 3% fee.
- After 18 payments of $250, your balance is $4,800 (including the 3% fee).
- Pay off the balance with a personal loan.
- Paying $250 a month at 10% gets you debt-free in 21 months at a cost of $452 in interest.
- Total costs to repay $10,000 over 39 months: $752.
If you just paid $250 a month on your card and your interest rate was 17%, it would take five years to clear the balance at a cost of $4,862!
The problem that up to 85% of consumers face when consolidating debt is that they forget they still owe the money. Transferring balances to different accounts does not make them magically go away.
You can increase your chance of success by creating a budget. Disable the "Buy it Now" button for online purchases and leave your credit cards at home when you go out. Force yourself to pay cash and impose a cooling off period for every unnecessary purchase.
By putting yourself on a spending diet until your balances are cleared, you'll ensure a fatter wallet in the future.