Key takeaways
- Personal loans are best for large, one-time purchases or bills.
- Credit cards are best for everyday spending and reward systems.
- Both can have a positive impact on your credit score if used responsibly.
- Check fees, rewards and repayment terms to compare these two financial tools.
Knowing when to take out a personal loan or use your credit card can prevent financial challenges down the road. They are both useful ways to handle an unexpected expense or a larger purchase, but there are some major differences in how you repay what you borrow.
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.
Personal loans vs. credit cards
A personal loan provides a lump sum — less any origination fees, if applicable. You make fixed monthly payments until your balance is paid. Loans are typically used for a large expense or debt consolidation.
A credit card is a revolving line of credit, meaning you can repeatedly borrow funds up to a predetermined threshold called your credit limit. Because of this, a credit card is typically best for ongoing daily purchases.
Key differences between personal loans and credit cards include repayment terms, interest rates and how you access your funds.
| Personal loans | Credit cards | |
|---|---|---|
| Average interest rates | 11.91% | 20.75% |
| Repayment terms | Make fixed monthly payments during a set period, typically between 12 and 84 months | Pay the minimum amount or the full accrued balance by the monthly due date |
| Type of interest rates | Fixed interest for the entirety of the loan | Variable interest that accrues on unpaid balances |
| How funds are disbursed | Lump sum: You’ll receive the full loan amount at once | Revolving line of credit: You’ll have access up to your credit limit |
| Fees | Origination fees, prepayment fees, late fees, among others | Annual fees, late fees, over-limit fees, foreign transaction 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 are both a way to borrow money that you must pay back on time. Consistently not doing so can damage your ability to borrow more in the future, or even qualify for housing or jobs.
Personal loans
Personal loans tend to have lower interest rates than credit cards and are geared toward large, one-time expenses.
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.
A few common reasons to take out a personal loan include:
- Consolidating high-interest debt.
- Paying unexpected medical bills.
- Completing home improvement projects.
- Covering 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 expensive trips are 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.
Pros
- Significantly lower average APR.
- Good for debt consolidation.
- Consistent monthly payments.
Cons
- No rewards, points or other benefits.
- Multiple fees.
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 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 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 could improve your credit in the long term.
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 than your current debt, which can save you hundreds of dollars or more.
A personal loan can also help pay for an important expense that can’t be saved up for, like home renovations or wedding costs. Using a personal loan instead of a credit card will likely involve less interest, so it can be useful if you know exactly how much you need and don’t want to carry a balance on your card.
Credit cards
Credit cards have rewards systems for frequent use, which makes them good for responsible everyday spending.
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 could 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.
A few ways you could use your credit card include:
- Making smaller everyday purchases.
- Paying for a well-planned vacation.
- Earning cash back.
- Taking advantage of a 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 also has the potential to negatively impact your financial health.
Pros
- Earn rewards and bonuses.
- Boost your credit rating.
- Convenient for everyday expenses.
Cons
- High interest rates.
- Potential for overspending.
- Multiple associated fees.
How credit cards affect your credit
If you pay your credit card off on time each month, you will 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 can increase your credit score. This is particularly 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 funds. Home equity loans, lines of credit and cash advances may also be useful ways to cover big expenses.
- Home equity loan: A home equity loan allows you to borrow a lump sum of money by using the equity of your home. 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.
Bottom line
While a credit card is good for getting rewarded for everyday purchases, it can lead to more debt if you outspend 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.
And keep in mind that using both is an option. For example, you may decide that you want to get a personal loan for a one-time purchase and apply for a credit card for regular spending.
