When life’s big expenses crop up, it’s always best to pay cash.
That’s why the first step in building financial security is to get ahead of your paycheck and save money for emergencies — and eventually big purchases like cars and vacations.
If you’re not there yet, sometimes you need to use credit carefully to ride out financial emergencies or afford a timely necessity. And most of the time, we simply reach for our closest credit card.
Although a credit card is convenient — most of us have one on hand with which you could easily pay for something over time — a personal loan is sometimes a better option for financing big purchases. Here’s a look at personal loans vs credit cards and the pros and cons of each.
What is a personal loan?
A personal loan is an unsecured loan that you can use for just about any purpose: debt consolidation, a vacation, even a horse.
A personal loan works more like an auto loan than a credit card.
- When you take out the loan you receive the loan amount in a lump sum.
- You make fixed monthly payments for the agreed upon term (number of months).
- Personal loans usually have terms between two and five years.
- Personal loans usually have fixed interest rate.
- There is no penalty for paying off the loan early.
Personal loans differ from credit cards which don’t put an “end date” on the debt. A credit card has a credit limit that you can use as often as you like. It’s up to you to pay the entire balance off at the end of the month or “carry a balance” and make small payments over time.
The danger with credit cards, of course, is that you can always charge more at any time up to your credit limit, keeping you stuck in debt. With a personal loan, you know when your debt will be repaid and that you can’t borrow more money without completing a new loan application.
Like a credit card, a personal loan is unsecured (as opposed to an auto loan or a mortgage, which are secured loans). The difference is if you stop paying a secured loan, the bank can repossess your car or foreclose on your house. For this reason, interest rates on personal loans are higher than secured loans but often lower than credit cards.
When is a personal loan better than a credit card?
Use a 0 percent APR credit card for smaller purchases you can pay off in a year or 15 months.
If you’re making a purchase of between a few hundred and a few thousand dollars that you want to pay off over a few months, the cheapest way to do it may be to apply for a new credit card that offers a 0 percent APR on purchases for between 12 – 18 months.
As long as you can pay the purchase off before the promotion ends, you don’t pay any interest.
Use a personal loan for larger purchases for which you need more time to repay.
If you need to borrow $1,000 or more and need more than 15 months to pay it off or you need to borrow $5,000 or more, which is higher than the credit limit on many credit cards, a personal loan may be a better option.
The biggest downside to some personal loans is that they may charge an origination fee of between 1 and 5 percent of the loan amount. This is a one-time fee that is paid in cash or from your loan proceeds at the time of closing. Not all lenders charge an origination fee on personal loans, but you need to ask about the fee and take it into account when comparing interest rates. One lender that offers you a better APR may actually be more expensive if they charge a fee and the lender with the higher APR does not.
Where to find personal loans
In addition, many banks offer personal loans to existing customers, although they may not be advertised. Credit unions often offer good rates on personal loans to its members and may offer you the best chance of being approved for a personal loan if you have a history with the branch.
Peer-to-peer lending sites — where regular people pool their money to make loans to others — offer another source of personal loans. (I personally used a personal loan from one of these sites to consolidate some credit card debt.) For example, Lending Club makes 3- or 5-year personal loans up to $35,000 for borrowers with FICO scores of at least 660.