Myth or fact? Credit cards and personal loans are practically the same.
"Personal loans and opening a new credit card are, at the core, the same concept," begins Brett Holzhauer, credit card writer at FinanceBuzz.com, "you are borrowing money with the promise of paying it back. However, the purpose and application of both of these products are vastly different."
In this article, we are going to explore the similarities and differences between these two financial products, as well as answer the big question: Should I get a credit card or a personal loan?
But first, let’s break down what credit cards and personal loans are and when it’s best to use one or the other.
What is a credit card?
On the most basic level, a credit card is a plastic card issued by a bank or other financial institution that allows you to borrow money to make purchases — generally smaller, every day purchases. Obtaining a credit card is quick and easy, and in many cases it is easier for consumers to receive approval for a credit account rather than a personal loan.
"Credit cards are meant for those with the financial means of paying their monthly statements," says Holzhauer, "while personal loans offer access to cash that you will pay off over a predetermined time in the form of debt."
Similar to a loan, you will be given a set amount of money, called a credit limit, when you open a credit account. This money can be used for making purchases or paying bills, and it is expected that you will pay back any money spent from your credit limit each month. However, credit cards have revolving credit, meaning that you can borrow more money as you pay off your debt, which can be both a good and a bad thing for borrowers.
Expanding on this point, Abigail Welles, content specialist at Credit Card Insider adds that “a credit card is considered 'revolving' debt, meaning you can continue to borrow money as long as you have not hit this limit. If you do not pay off your balance, you’ll get hit with interest, which can effectively keep [consumers] in debt."
Credit card pros and cons
Credit cards can be a great option for some borrowers, but perhaps not all. Before deciding on using a credit card for your spending needs, consider both the pros and cons.
Opening a new credit card can help improve your credit score, and there are various credit factors that can contribute to this. Making on-time payments is one of the more important and efficient ways to build credit with a credit card. As you use your card and make payments, this activity is generally reported by the card lender to the national credit bureaus — Experian, TransUnion, and Equifax. Based on this information, the credit bureaus are then able to create your credit score. If you miss payments, however, this will not only impact your credit score, but you could get hit with high interest rates that can accrue on an outstanding balance over time.
Various types of credit cards offer rewards or points for travel, or even cash back on purchases. These benefits can be a great incentive to use the card, but may not be profitable if you don’t make on-time payments. Some credit cards even have introductory offers, such as no interest rate periods that provide flexibility if payments are missed. Most personal loan providers do not offer introductory services.
It is important to note that credit cards may also have fees, such as annual fees, late fees, and cash advance fees.
Key Takeaway: Credit cards are best for smaller, everyday purchases. They are also a good option in the following circumstances:
- You need extra cash.
- You are a responsible borrower looking for rewards.
- You can pay the balance off before any interest accrues.
- You want to make online purchases.
- It's for emergencies or occasional spending.
Top credit card companies
The top three credit card companies on BestCompany.com include:
Based on customer reviews, each company is comparable, receiving high ratings. Customers generally highlight good customer service as well as competitive rates and rewards.
Each company offers multiple credit card options, providing more flexibility for consumers of all credit levels.
What is a personal loan?
Personal loans are types of installment loans that provide borrowers with a fixed amount of money which they are responsible for paying back throughout the life of the loan, which could be as short as one year or up to five years and beyond.
If you need a large loan amount, a personal loan would be the best option for you. Some personal loan lenders offer up to $100,000, which provides greater flexibility for whatever you are looking to finance. For large expenses such as home renovation or unexpected medical costs, credit cards may not be the best choice, as you will not likely be able to get a substantial amount of money.
Personal loans pros and cons
Because personal loan lenders offer larger amounts of money, it can be more difficult to be approved than for a credit card. To this point, Dane Janas, an IRS-licensed Enrolled Agent, host of the Financially Boundless podcast and YouTube channel, and CEO of Boundless Tax adds, "Generally, the underwriting is more advanced as well, so you stand a lesser chance of actually being approved if you have less-than-stellar credit."
Personal loans will generally have lower interest rates than credit cards. The higher your credit score, the lower rates you will be able to receive. It is important to note that credit cards generally only have variable rates, while personal loans offer fixed interest rates in addition to variable rates. The fixed rate option with personal loans is nice because you will know from the start what your monthly payments will be, and they will never change throughout the life of the loan.
Personal loans do not have revolving credit, meaning that you will not have access to more funds as you pay off your loan. Instead, each monthly payment goes toward the entire loan amount.
Take note that personal loans also have their own set of fees. Many lenders have a late fee and a loan origination fee, which is generally withdrawn from your total loan amount before funds are disbursed to you. In addition, you may be charged a prepayment penalty fee, which is applied if the borrower pays off their loan before the term is complete.
Key Takeaway: Personal loans are best for large purchases. They are also a good option in the following circumstances:
- You have good credit and are confident in your ability to make payments.
- You are looking to consolidate debt.
- You have unexpected expenses.
- You have a good credit score that can get you low interest rates.
Top personal loan companies
The top three personal loan companies on BestCompany.com include:
Although Best Egg is the highest rated personal loan company on BestCompany.com, customers have also been pleased with their experiences with FreedomPlus and SoFi. When deciding between each company, it is important to look at APR rates, maximum loan amounts, and the average credit score requirement for each company.
Which is best?
Depending on your financial needs, a credit card could be a better option than a personal loan and vice versa.
More than anything, consider the reason for which you are borrowing money, as well as interest rates and fees. In either case, be sure to make on-time payments, which can save you from future financial stress or difficulty.
In addition, you can consider the following when deciding which is best for you:
- Purchase intent — Ask yourself what you will use the funds for. A big, one-time purchase? Or smaller, more frequent purchases?
A credit card is better for everyday purchases, while a personal loan may be the best option for a one-off major purchase.
- Credit score — It is important to consider your current credit score when looking to borrow money either through a credit card or personal loan. If you have a low credit score you could have a more difficult time being approved for a personal loan, which may not be the case with a credit card. Personal loan interest rates are also contingent upon your credit score. The higher your credit score, the lower the rates you will receive.
- Interest rates — Credit cards generally have higher interest rates than personal loans. Consider filling out a pre-qualification form in either case to see what rates you will be offered, but it would likely only be wise to do so if a soft credit pull is performed.
- Spending behaviors — If you are prone to over spending, a credit card may not be the best option for you. Whether you choose a credit card or personal loan for your financial needs, be wise and consider making a payment plan to keep yourself on track. Spending too much money, missing payments, or not being able to make payments could have negative repercussions.
The bottom line
The decision between a credit card and a personal loan is entirely dependent on your financial needs and circumstances, and it is important to carefully consider those details before jumping in with either option. No matter which you choose, be sure that you will be able to manage and make payments, so you have an opportunity to grow your credit and make those important purchases in your life without creating any future financial stress.