Personal Loans versus Credit Cards: What is Better?
Both personal loans and credit cards offer a lot of benefits. And they are both advertised on a very constant basis, so they cannot really be ignored. When it is time to choose one, however, confusion can set in, and that is never a good feeling. It is also not good for decision making. In my firm belief, knowledge is actually power. When I am educated on something, I feel much more confident, and I am much less likely to make a bad choice. On that note, let’s dive into how personal loans versus credit cards work, how you can benefit from them, and how they compare to one another.
How Credit Cards Work
It was only recently that I learned that there are many people who do not know how exactly credit cards work. And who can blame them, really? When you sign for a credit card, you get a long list of terms and conditions that give you a headache to read, and hives trying to understand. That’s if you do not fall asleep by the third section or so. Be honest, how often have you read all of the terms and conditions? How often have you skimmed or just completely bypassed them? Nobody? Yeah, me neither (ahem).
In truth, though, there are few people who really know all that they need to know about credit cards. This lack of knowledge is usually what gets them into trouble. So let’s just break it down a little bit. In the most basic explanation, when a credit card company decides to lend money, they attach said money to a card. You swipe the card, the money is subtracted from your account, and the credit card company covers the purchase with that.
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Now, they have actually loaned you some of that money, and they are going to charge you interest. Interest is really just a fee you pay for borrowing the money. Simple enough? The problems come in when the credit card holder does not know the interest rate or how it is calculated, what fees come with being a cardholder, or that the minimum payment due is way less than what should actually be paid. For future reference, just in case you want to skip over the terms and conditions, at least look for the three things listed below and be sure you understand them.
Some credit card companies charge different fees in addition to the interest. Here are some of those fees and what they mean to you:
-Late Payment Fee:
This is pretty self-explanatory but do understand that if you have a late payment fee by the end of the billing cycle, you will probably get charged interest for that too. A $30 late payment fee can quickly double or triple if interest continues to grow.
-Returned Payment Fee:
This is simply when you make a payment but do not have the funds to cover the payment, which can lead to more interest just like a late payment fee.
Some, though not all, credit card companies charge annual fees. Before you run away from that fee, though, check out what the card can offer you. No one wants to pay a fee but if you that fee is only $20 and you get $300 worth of perks you can use, I would say it’s worth it. Do your research here and checkout reviews from other customers.
-Cash Advance Fee:
Many credit cards will allow you to withdraw your credit as cash, but they usually charge a fee for it. While this option is great when you are ina cash pinch, it may cost you more than its worth.
This is very simply the extra money you pay if you use more than the credit card company approves. Going over your limit is not possible on all cards. Some set very strict limitations, which is good since it keeps you from over-spending. It is important to know from the beginning whether or not this is possible with your card.
You might notice other fees mentioned on your terms and conditions, like foreign transaction fees. Unless you travel outside of the country, this will not affect you. If you do travel to other countries, learn this fee, as well. For any other fees that you do not recognize, ask your credit card company to explain them to you.
It is really, really, really, super duper important to understand your interest and how it gets added on. First and foremost, know your interest rate. You can find credit card interest rates all over the place. You might find a 0% APR credit card, then again it may go up to 30% APR. Typically, they fall somewhere between 13% and 23%.
Now for a little math lesson, and a little vocabulary along the way. Unless your credit card says otherwise, your interest will be compounded. If you Google compound, you will notice that it is described as something being added onto something else, a mixture of things, and so on. My favorite definition of compounded when referring to interest is a little lower down the page. As a verb, compound means “to make something bad worse”. Yep- I think that about explains it.
If you look back to the first definition, you may be wondering how this all applies to interest. Every month that you owe money on your credit card, you get charged interest and that interest is added to your regular balance. The next month, interest is added again, but it does not just get added to the amount you have used. You are also charged interest on last month’s interest. And that continues until it is paid off.
Let’s take an example:
So, if you spend $200 of your $500 credit limit, and your interest is 20%, you owe $240 the first month. You make a minimum $20 payment, which leaves your balance at $220, so $20 of that is still interest. The next month, if you have not used any additional credit, your interest will be calculated with your balance of $220. The interest would be $44, making your balance $264- $64 of which is interest. Again you make a minimum payment and again you still have interest.
Do you see what I mean? Every month, interest is just piled on top of itself, and if you carry on paying just minimum payments, you will find yourself in a debt hole so big that you cannot see the light. Make sure that you understand your interest before you use your card.
Carrying on from the last section, credit card payments can be tricky little guys, too. When you get your terms and conditions, look at the minimum payment amount. Now, do yourself a favor: multiply your credit limit by your interest rate. That is the amount of interest you will owe if you had to use every bit of your limit, so it’s your worst case scenario. Does your minimum payment cover that amount? Most likely not, so you will have to pay more than the minimum payment to stay above water. At the very least, you need to pay your interest and as much extra as you can to pay off your balance.
It is also important to understand that credit cards affect your credit in more ways than just saying you pay or you do not. They can affect your credit utilization, which is a big deal. Lenders want to see that you have money available to you but that you are in good enough shape, you really do not need it. Ideally, they want to see that you are using 30% or less of what is available.
So every time interest is compounded on your credit card, it shows as you using more of your credit. Your credit is going down over something that you did not even get to enjoy because 90% of it was interest. I don’t know about you but if I am going to go into debt over something, I would at least like to get some enjoyment from it.
How Personal Loans Work
Personal loans work a bit differently. You get approved for a loan, the lender gives you your cash- or a check or direct deposit. You are sent home with a payment plan. If you follow it, you will have your loan paid off on time. A minute ago I mentioned credit utilization and how a credit card can affect it. A personal loan can, too, but it happens in a different way.
Any time you open up a new account, your credit is affected. Over time, it will either improve your credit or make it worse. With a credit card that continues to compound interest, it will just get worse and worse. With personal loans versus credit cards, the biggest hit to your credit is the initial one when you get the loan. As you make payments and decrease your balance, your credit improves.
Obviously, you can do this with a credit card, too, if you can pay the balance in full each month. It is just that it is often easier and more attainable for a personal loan to improve your credit. When you are not fighting an uphill battle with interest, you can usually pay things off more quickly. In one way, personal loans are no different than credit cards, and that is that you have to know your fees, interest rates, payments, and how it all works. Any time you sign a financial contract, you need to understand it. Below are some things to look out for and understand.
Some personal cash loans do have fees attached to them, but you can find loans that do not. Two of the most common fees you might run into are application fees and origination fees. Application fees cover the costs of actually processing your application, so they are non-refundable. They also must be paid before they start the process.
Origination fees cover any costs that might be associated with the lender giving you the cash, such as processing fees. This amount is usually a percentage of your loan and taken out of the loan upfront. If you are approved for a $1,000 loan that has a 10% origination fee, you will actually only receive $900. This means that if the lender charges an origination fee, you need to apply for more than you need so you still get the full amount.
As previously stated, not all loans require fees. When you do run into them, they will vary between loan places. You can always ask up front what fees might be required, or read the terms and conditions, as lengthy and boring as they may be.
Smart Money Tip!
Typically, interest rates will be much lower for personal loans than they will with credit cards. You will often find them between 5% and 36%, with higher credit scores getting lower interest rates. The good thing about personal loan interest rates is that with most loans, the interest is calculated for the entire loan at the beginning, and then it is spread out over monthly payments.
So, even if a credit card’s interest rate is lower than a loan you find, check how the interest is determined and whether or not it is compound. A credit card with even 2% interest can grow into a monster if the interest is compounded monthly.
Loan payments are also typically different from credit card payments. With a personal loan, you can get fixed interest and fixed payments for a fixed term. If you get a personal loan for the $500 instead of the credit card, your monthly payments will look much different. We’ll say that the interest on the loan is high at 36% and your repayment term is one year.
$500 x 36%= $180 Interest
$500 principle + $180 Interest= Total Due $680
$680 / 12 months= $56.67 per month (including interest)
That is a little more than double the credit card’s minimum payment and yet you will have it all paid off in one year. With the credit card, you could literally owe for the rest of your life.
How to Choose Between Personal Loans versus Credit Cards
We are now down to why you came to this article: you need to know how to choose between personal loans versus credit cards. Here’s the thing- choosing between them is really all about what you need and what you plan to do. Before you go any further, you need to be clear on your goal. Are you looking for a way to pay a bill? Buy a home? Buy a car? Go on vacation? Or just build up some credit?
Hopefully your goal is not just to spend money for fun, but if that is your goal, be honest about it. What you need the money for will often tell you which one you need between personal loans versus credit cards. For instance, if it is a really short term loan that you can pay off in a couple of weeks, like gas or groceries, a credit card would be better. The following are times when you should definitely look for personal loans versus credit cards.
If You Need a Large Amount
When you need a large amount of money that you cannot pay back quickly, choose personal loans versus credit cards. Again, the interest will be calculated and spread out in manageable payments. Using a credit card for a large amount is more than likely going to dig you a very big hole.
When You Need to Borrow for a Long Period of Time
When comparing personals loan versus credit cards to use for a long time, personal loans most definitely win. Think about the interest we talked about. It is just going to grow and get larger over time with credit cards. Personal loans spread your interest and payments out over the full term, which is typically between one and three years, though it can vary. Personal loans were designed for long repayment periods. Credit cards were not.
If You Need Cash
This may seem obvious, but credit cards are not cash. You can get cash advances from credit cards, but there is likely a fee associated with that- and a hassle. On the other hand, a personal loan is cash. Even if it is handed to you in the form of a check, you can take it to the bank and get cash without an additional fee. If you need the money specifically for a cash transaction, like maybe paying your best friend back or even paying your landlord who has not way to accept a credit card, a personal loan would be more convenient.
When You Need to Consolidate Debt
Let’s say you owe $2,000 in debt. Thanks to the interest on all of these debts, you need to pay $500 per month just to keep the bill collectors off your back, but that $500 is not really helping you get out of debt. Instead of working yourself to death, try applying for personal loans versus credit cards. If you are approved for a $2,000 loan at a 14% fixed interest rate, the entire interest is $280. If you use that loan to pay all of the debts off, you only owe one payment. So there is the convenience, but there is another bright side.
Even if your repayment term is only one year long, your monthly payment will only be $190. That is almost one third of what you were paying every month when you were paying separately. The even better part is that, as long as you make your monthly payments, your loan will be completely paid off at the end of your repayment term. So in short, you are making one lower payment with lower interest to get everything paid off with personal loans versus credit cards or separate debts which can be endless.
When You Need Set Payments and Terms to Actually Pay Off
Your monthly payments with credit cards depend on how much credit you have used. If you have used $200 and your interest rate is 20%, you will owe $240. However, that is probably way more than the amount that the bill states as due. In fact, if I have not made it clear enough, that is the big way that credit card companies make money. If you only pay the minimum amount, it is not even going to touch the full amount due.
The following month, even if you do not use the card again, you will owe more. This is because interest is calculated again and it includes the interest that you did not pay off the previous month. It is a tangled web that just spreads as long as you will let it. All the credit card company needs is your minimum payment. As long as you are paying that, they will also let the web continue to grow.
Personal installment loans, on the other hand, generally have a fixed interest rate and fixed monthly payments that are due for a certain period of time. When that time is up, your loan should be paid off. When you pay your monthly bill, you are working toward the principle as well. You know how much is due every month. While you can expect the same minimum payment for the credit card each month, that amount is actually putting you in a deeper hole- I repeat this fact because I really want these words to stick in your head. The bottom line is that when comparing personal loans versus credit cards, if you want a fixed monthly payment that will eventually end, personal loans win.
If You Don’t Need Additional Temptation
I definitely do not need additional temptation. With a personal loan, I know how much I am approved for. I know off the bat how much I have to use, so I tend to be more careful. If I get a loan for $4,000 to buy a used car because my car stopped working, I know that I only have that $4,000. I cannot spend that money on anything else or I will not have the money for the new car. We have to have a car to get around, so unless my children are starving or without necessities, that loan will only be spent on the car.
This can be different with a credit card, even when you know better. Let’s say I got a credit card with a $500 limit for the purpose of emergencies and necessities in between checks. Sounds reasonable and like a great idea- until one of my kids needs new shoes. I can find a way to hold off on the shoes, but it is just so much easier to get them on the credit card and tell myself it’s no big deal. That might be true with some people- some really strong willed people.
Me, on the other hand, as soon as a bill with a disconnection notice comes in the mail, I would probably use the card again. Maybe even when I just had a bad day and “need” some ice cream to make it better. And then again when my kid needs those shoes. Why? Because like many people, I live paycheck to paycheck, and sometimes those paychecks are not enough, especially when your car breaks down or the laptop you use for work stops working.
A credit card gives a convenient way out.
Most people are aware that a credit card needs to be repaid, but they also know it does not have to be paid just yet. When you are drowning in a sea of financial struggles, a credit card seems like a life line. It can ease that weight for the moment. It can provide things that we need and want right now instead of having to wait and save. In a world of instant everything, is it any wonder that we expect and choose instant gratification and solutions?
When it comes to personal loans versus credit cards, credit cards definitely have their advantages, but those advantages come at a very steep price. For these reasons, I feel safer taking out a loan than opening a credit card. How about you? Can you responsibly handle a credit card? Or will it get you into more trouble? If you know that a credit card is not a good idea in light of your will power and spending habits, go for a personal loan instead.
I hope you have enjoyed and gained some insight from the comparison of personal loans versus credit cards. And I hope that you are confident enough to make good choices. When it is time to look for a personal loan or compare credit cards, let us here at Loanry, help you find a lender that might be a good fit for you.
Brandy Woodfolk is an educator, home business owner, project manager, and lifelong learner. After a less than stellar financial upbringing, Brandy dedicated her schooling and independent studies to financial literacy. She quickly became the go-to among family, friends, and acquaintances for everything finance. Her inner circle loves to joke that she is an expert at “budgeting to the penny”. Brandy dedicates a large portion of her time to teaching parents how to succeed financially without sacrificing time with their little ones. She also teaches classes to homeschooled teenagers about finances and other life skills they need to succeed as adults.
Brandy writes about smart money management and wealth building in simple and relatable ways so all who wish to can understand the world of finance.