When life’s big expenses crop up, it’s always best to pay cash. But what if you can’t? If you don’t have emergency savings and suddenly face a car repair, tax bill, or some other major expense, you may have to borrow money to pay it. And most of the time, we’d just pull out one of our favorite credit cards.
There is, however, another option.
Personal loans – also called signature loans – may or may not be a smart alternative to credit cards to finance fixed expenditures.
What is a personal loan?
A personal loan acts like an auto loan, for example, with a fixed repayment term, interest rate, and monthly payment. In this way, 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 much of — or as little of — as you like. You can then choose to pay the entire balance off at the end of the month or “carry a balance” and make small payments over time.
Unlike auto loans — but like credit cards — personal loans are unsecured. That means if you stop paying on a personal loan, the bank can’t come to repossess something (as they would your car on an auto loan). For this reason, personal loans have higher interest rates than car loans. There are also limits to how much you can borrow.
When is a personal loan better than a credit card?
If you need to borrow between a few hundred and a few thousand dollars for a one-time expense, a personal loan may offer a better interest rate than the regular interest rate on your credit card.
Additionally, when you apply for a personal loan, you will choose your monthly payment and loan repayment period up front, so you know you will be making progress towards paying down your loan each month. With credit cards, it’s easy to get stuck in the minimum payment trap, never making headway on your balance and throwing money away on never-ending finance charges. If you’ve gotten stuck with credit cards before, you may pay off your debt faster (and pay less in interest) if you take out a personal loan.
Where to find personal loans
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 $25,000 for borrowers with FICO scores of at least 660.
When is a credit card better?
If your expense is small enough that you can repay it with a year, a credit card offering a 0% introductory APR on purchases is obviously better than a personal loan, as you will pay little or no interest. The Discover it Card — for example — offers 0 percent interest on purchases for 18 months.
Using a 0 percent APR credit card for a one-time large expense comes with two caveats: you must be able to stick to a schedule of monthly payments that will get your balance paid off in a year, and you must avoid putting additional charges on the card. Having a balance at the end of the intro period will subject you to the card’s high regular APR.