Two of the most common options for borrowing money are taking out a personal loan or using a credit card. But what are the pros and cons of each, and how do you know when to pick one instead of the other?
Here’s a closer look at the differences between personal loans and credit cards so you can compare them and decide.
How do personal loans work?
A personal loan is a specific amount of money that is lent to you in a lump sum. Most personal loans are considered installment loans, since you pay the loan back in equal amounts via regular monthly payments or “installments."
Unlike a credit card, you don’t gain access to more credit as you pay off the loan. Your balance simply goes down as you make payments. Personal loans also usually have a fixed interest rate, which means it will stay the same for as long as you have the loan.
The actual length of personal loans can vary (18 months, 36 months, etc). Some loans allow you to pay off the balance early without any prepayment fees. Read the terms and conditions of the personal loan offer carefully.
How do credit cards work?
When you use a credit card, you are borrowing the issuer’s money to buy things, and then paying it back later. Credit cards come with a set amount of credit you have access to. The amount you haven’t spent yet is called available credit, while the amount you have spent and need to pay off is called your balance.
As you pay off your balance, your available credit is restored. Both your available credit and your balance can be carried over month to month. This is why credit card debt is considered “revolving debt.”
It’s important to try to pay your balance in full and on time each month. Credit card debt is usually subject to compound interest, which can add up quickly. What this means is that your minimum monthly payment is calculated by adding your previous unpaid balance + interest on that balance + any new charges. Credit card interest rates can change based on your credit score and other factors.
Is it better to use a personal loan or a credit card?
Here’s three things to consider when choosing between personal loans and credit cards:
1) Type of purchase
Personal loans are typically used for larger, long-term purchases that the borrower intends to pay off over time. By taking out a loan, the borrower can keep the cost separate from other debts and credit accounts. Common uses include medical bills, auto repair bills and home improvement. Another popular use is debt consolidation
Credit cards can be ideal for smaller, short-term expenses that can be paid off quickly. Common uses include gasoline, dining out and clothing
2) Availability of funds
Personal loans – The availability of funds may not be immediate, but some lenders can provide a same-day response to an application. If approved, they might also disburse the funds the same day. Most personal loans are paid out in a lump sum and delivered via paper check or direct deposit to a bank account.
Credit cards – The availability of credit depends on your spending and payment habits. If you have enough available credit to make a purchase, the funds should be accessible right away. All you need to do is swipe the card or type in the account information.
3) Monthly budgeting
Personal loans – Most personal loans have fixed interest rates and payment amounts throughout the life of the loan. This makes the effect on monthly cash flow more predicabtable and may make it easier to manage a monthly budget.
Credit cards – While some credit card interest rates are fixed, others can fluctuate due to missed payments, a drop in credit score and more.1 If your rate does change, the rising interest costs could increase your monthly payment.2 The minimum payment for credit cards can also fluctuate based on how much you spend on the account.3 If you continue to charge purchases, or suddenly add a large purchase to the account, the minimum payment could get higher and make it harder to budget.4
At the end of the day, the core difference is that a personal loan has a definite end date and is used for a specific purpose, like getting out of debt. A credit card is an ongoing, general purpose line of credit that will last for as long as you keep the card.
For smaller, everyday purchases a credit card might be the way to go. For debt consolidation, major purchases and life expenses, a personal loan could be a better option.
1. Konsko, Lindsay. “5 Times Your Credit Card Issuer Can Raise Your Interest Rate.” NerdWallet.com. https://www.nerdwallet.com/blog/credit-cards/credit-card-issuer-raising-interest-rate-5-times/ (accessed December 19, 2017).
2. Konsko, Lindsay. “Why Does My Credit Card Minimum Payment Keep Rising?”. Nerdwallet.com. https://www.nerdwallet.com/blog/credit-cards/credit-card-minimum-payment-keep-rising (accessed December 19, 2017).
3. Konsko, Lindsay. “Why Does My Credit Card Minimum Payment Keep Rising?”. Nerdwallet.com.
*This article has been updated from its original posting on March 25, 2016. Matt Diehl contributed to this article.