In an ideal world, all household expenses would be paid for in cash.
You’d just open your wallet, take out the required cash, and be done with it.
The reality? Few people have enough cash in their savings account for even minor emergencies.
According to a recent survey, only 37% of Americans have the savings necessary to pay for a $1,000 need.
The convenience and simplicity of these new solutions are undeniable. But if not used properly, the financial consequences can be disastrous.
This begs the question: Which option is better for your situation? Credit cards or personal loans?
Personal Loans and Credit Card Debt Explained
When to Take a Loan
Not all forms of borrowing are created equal. In order to judge which is best for you, we need some basic criteria to help us choose.
The easier it is to access funds in an emergency the less stress and hassle you have to deal with, allowing you to focus on the situation at hand.
When Hurricane Katrina struck New Orleans, and thousands saw their homes destroyed, easy access to emergency funding had a huge impact on how easy or difficult it was to get through the crisis.
And while our day to day emergencies are rarely so extreme, it’s impossible to underestimate the value of having quick access to capital when it’s needed.
Every borrowing method comes with unique terms. That is, how long you have to pay off the borrowed amount, at what interest rate, and any other special conditions that may affect your payments.
For example, mortgage terms may include a repayment period of 15 years or less all the way up to 50 years.
Such loans may also feature a fixed interest rate for their duration or a variable interest rate that adjusts yearly after an initial “locked in” period.
The terms affect how much your monthly payments are and how long it will take to pay off the loan.
For example, with a 15-year mortgage you’ll incur less than half the interest charges that you would with a 30-year mortgage. However, your monthly payments will also be significantly higher.
C. Total Cost:
Even if a loan has low monthly payments, it’s not necessarily a winner if the total cost is high.
The example - let’s see how these criteria can help us choose between credit cards and personal loans.
How Personal Loans Work For You
A personal loan is a form of borrowing in which the borrower receives the loan amount in full, and must make fixed payments (including principal and interest owed) for a specified term, usually a few years.
Unlike with credit cards or lines of credit, if more money is needed, the borrower must reapply or complete a new loan application.
Allowing interest to accrue can quickly lead to debt that spirals out of control.
Some common uses for personal loans are:
- Debt consolidation
- Home renovations
Main Advantages of Personal Loans
One of the big advantages of a personal loan is that you don’t have to put up collateral such as a house or car in order to get one.
These are called unsecured personal loans. Interest rates on unsecured loans tend to be higher than those for secured ones (since banks have few options if you stop making payments).
If you have a secured personal loan and fail to make payments, the bank can repossess the collateral you put up.
Another advantage is that you can use a personal loan for almost anything.
Pretty much the only things you can’t use a personal loan for are investing, gambling, and education expenses.
Now of course that doesn’t mean that just because you can use a personal loan to throw a party for all your friends you should, but in principle, this sort of flexibility is quite advantageous.
Personal Loan Drawbacks
Of course, despite all these advantages personal loans have their drawbacks as well.
In general, personal loans have higher interest rates than equivalent home equity, business, and auto loans.
Though, if your credit is good and you apply for a secured personal loan - one with collateral, it is possible to get similarly good interest rates.
Another potential disadvantage is that personal loans are 1-time, fixed-amount transactions. If something else comes up and you need additional funds, you have to apply for a whole new loan.Here are more pros and cons of personal loans.
How Credit Card Debt Works
In fact, According to the Federal Reserve Bank of Boston's Survey of Consumer Payment Choice (published in 2011), 72.2% of consumers have a credit card. The average consumer who uses any sort of payment cards has an average of 3.7 credit cards.
So with all that plastic floating around, where do we end up using credit the most?
- Online shopping
- Daily expenses
- Emergency expenses
Essentially, we use credit cards as a replacement of both cash and checks (remember those?)
Main Advantages of Credit Cards
The main advantage of credit cards is convenience. No having to carry around cash or write out checks.
Plus, credit cards enable us to make purchases even if we don’t have the money yet.
For example: If you need to buy a replacement window and payday is a week away, you won’t be stuck feeling a cool evening breeze all week while you wait for your paycheck.
Credit cards allow us to spend up to the credit limit, to be paid off at some later date.
And that’s another advantage: Payments are due monthly with only a specific minimum required (1-3% of the total credit card balance).
This means that if some emergency arises that prevents you from paying off the full balance, you can shift repayment to a later date by paying just the minimum required.
This isn’t good for your credit score or interest payments, which can rack up quickly but it can help you get out of an emergency when cash is hard to come by.
Credit Card Disadvantages
If you don’t pay off your balance, then you’re going to be exploring the world of credit card disadvantages.
Looking for a better card?Don’t ignore these 15 credit card truths.
Credit card interest rates are typically high. 15% is common and in certain extreme cases, interest can be nearly 80%. Since payments are due monthly and are based on the accruing balance, they become harder to pay as time goes on.
Because of this, credit card debt can be difficult to manage. According to the G-19 Credit Card Report by the Federal Reserve, the average American household in May 2016 owned $7,814 in credit card debt.
How do you choose whether a credit card or personal loan is best for your situation?
Let’s find out.
Personal Loans vs. Credit Cards: a Comparison
As much as we’d love to declare a cut and dry winner, when it comes to personal loans and credit cards, there is no best choice that covers every possible scenario.
Each option has advantages and disadvantages. Your specific financial situation, the expense itself, and personal preference are the deciding factors.
When Credit Cards Are Better
1. When Further Borrowing May Become Necessary
Credit card debt is revolving debt. You don't need to apply for more credit until you reach the credit limit. This flexibility lets you make multiple purchases as new or unexpected needs arise.
Suppose you're faced with an emergency medical expenses over $5,000. Unless you have the cash on hand, you'll probably need to borrow the funds.
If you take a $5,000 personal loan you'll be able to pay the initial expenses. But what if there are additional, related expenses? Medical proceedings are rarely that predictable. And furthermore, what if the toilet breaks or your car needs repairs?
Using your card to pay the $5,000 (assuming your credit limit is more than that) gives you flexibility if any other expenses come up.
2. Short-term Borrowing
With credit cards you can borrow short-term with no repercussions no interest accrued as long as you pay off the balance each billing period. With a personal loan, you owe interest on the borrowed amount immediately.
This makes credit cards great for financing big purchases when you can pay off the balance within a 30 day period. Some credit card issuers even offer grace periods of several days to allow the borrower to make their payment without incurring late penalties.
So, if you want to pay for an all inclusive trip to Cancun for your winter vacation, while you definitely could use a personal loan, by using a credit card and paying it off as soon as you come home (assuming this is before the billing period ends), you’ll pay no interest.
Do the same thing with a personal loan, and you’re probably looking at around 7% interest for the duration of the loan.
3. No Hidden Usage Costs
Credit cards have no administrative cost. In other words, a borrower is not required to pay additional fees to use their credit card.
You can make one transaction or 100, and the credit card company doesn’t care. There are no fees in either case.
With some personal loans, however, the borrower must pay an origination fee equal to a percentage of the total loan amount.
Important Note:Always ask what your personal loan's origination fees are. Some lenders may compensate for low-interest rates by assessing a higher large origination fee.
Personal Loan Advantages
1. Fixed Monthly Payments
With personal loans, payments (accounting for both principal and interest) are fixed until the debt is paid, helping borrowers budget appropriately for the term of the loan.
This is radically different than credit cards, where the interest is always relative to your outstanding balance, and where payments can get out of control in a hurry if not properly monitored.
2. Lower Interest Rates
Interest rates for personal loans are generally much lower than those of credit cards.
If you're considering a large purchase that you can't pay back immediately, the lower interest rate can potentially save you a large amount of money.
This is particularly true because your credit card interest payment is relative to the balance, whereas your payments for a personal loan are predetermined and fixed.
3. The Advantage of Limited Flexibility
Ever struggled with credit card debt? The limited flexibility works in your favor.
With a personal loan, you receive only the amount you're approved for. If you need to borrow more, you will have to apply for a new loan.
This creates a natural barrier that may prevent excessive spending and abuse.
Variety: The Spice of Effective Borrowing
Personal loans and credit cards are not all created equal. Before settling for a "standard issue" product, take a look at these variations. They could be exactly what you're looking for.
Zero Percent Interest Credit Cards
Several credit card issuers offer introductory 0% interest incentives to new applicants to encourage sign-ups.
New borrowers can make purchases and pay them back over an extended period (up to a year or more, in some cases) without accruing any interest.
Unfortunately, these rates usually last for 6 to 12 months only. And the credit is (usually) limited to smaller purchases of a few thousand dollars.
Still, this is much better than being hit with interest charges of 15% or more just because you forgot to make a payment once.
Peer-to-peer Personal Lending
Peer-to-peer lending platforms (such as LendingClub and Earnest) lower the operational costs associated with standard personal loans by connecting borrowers with lenders.
As a result, some cost savings are passed on to borrowers in the form of lower interest rates than other lenders.
These platforms have minimum FICO credit score standards for borrowers, and can be a good option if your credit score is high enough.
When you don’t have the cash to pay for large purchases or other expenses, both credit cards and personal loans have advantages that could make them the right option for you.
It really comes down to the size of the purchase and your ability to pay it off. By understanding your own spending habits and capabilities, you’ll be able to pick the best option for you.
Now it’s your turn: What experiences have you had with personal loans? With credit cards? Do you have a preference?