You’ve decided that you need to borrow some money, but you don’t know exactly which type of loan will be best for your needs. Two of the most popular types of loans are personal loans and credit cards — but you don’t have to be a personal finance expert to know that they are both very different ways to borrow money.
Below we highlight the pros and cons of a personal loan vs. credit card to help you find out which one is best for your needs.
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What Is a Personal Loan?
A personal loan is a type of installment loan where the lender provides the borrower with a lump sum of money that they can use for a variety of purposes, such as making home improvements, covering car repairs, or consolidating debt.
Whether using a personal loan to pay down medical debt or pay for a vacation, personal loans can provide you with funding to meet your goals.
Generally, personal loans are paid back each month in fixed payments, or installments, with interest. Repayment is typically spread over a period of 12 months to seven years. You can use a personal loan for emergencies and financing major purchases.
Personal loans can be either secured or unsecured. An unsecured personal loan is an installment loan that’s not secured by any property such as a home or vehicle, whereas a secured personal loan is backed by some type of collateral. (Learn more at Personal Loan Calculator)
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How Does a Personal Loan Work?
A personal loan works like an installment loan that gives the borrower a lump sum of money — not revolving credit — that can be used for a variety of purposes. The borrower typically repays the loan over a set term, and these required payments may go toward principal, interest, and fees.
Typical Personal Loan Requirements
The requirements for personal loan funding typically require the borrower to provide proof of identity and proof of income. Lenders may review your creditworthiness when determining whether to approve or deny your personal loan application.
Typical Personal Loan Terms
Each lender can determine the terms and conditions of a personal loan, including the annual percentage rate (APR) comprising the interest rate and upfront fees. Borrowers with excellent credit may receive a lender’s best APR, whereas borrowers with bad credit may receive less favorable terms if approved for a loan.
Personal loan amounts may range from $1,000 to $100K. Personal loan repayment terms typically range from 12 months to seven years. You may compare personal loan rates and select an offer from the lender of your choice.
When to Choose a Personal Loan
A personal loan can be ideal for making large purchases. This simple type of loan allows you to break down a big purchase into smaller monthly payments that you spread out over time. A personal loan can also have lower interest rates than some other types of loans, including credit cards.
Generally, interest rates are lower for secured vs. unsecured personal loans, though with the former you run the risk of losing your collateral.
One of the top uses for a personal loan can be to consolidate your debts, especially those with high interest rates. And it’s also a great type of loan for people who would prefer to be committed to making the same payments each month. There are even personal loans available after bankruptcy.
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What Is a Credit Card?
A credit card is a financial instrument that represents a revolving loan. When you use a credit card to pay for something, the credit card issuer (e.g., your bank) covers the cost of the purchase with the understanding that the cardholder will pay back the amount borrowed, plus any interest that applies.
When credit card users pay their entire statement balance in full by the statement due date, nearly all credit card issuers will waive interest charges. Credit cards typically represent an unsecured loan, so there’s no property that can be repossessed if credit card payments aren’t made. And while using a credit card irresponsibly can certainly damage your credit card, they can also help build it — in fact, there are a number of top credit building cards out there.
Credit card users also enjoy robust security protections against fraud and billing mistakes. They can also offer rewards in the form of cash back, points, or miles. And finally, credit cards can provide travel insurance policies, purchase protection benefits, and other perks.
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How Does a Credit Card Work?
A credit card works like revolving or open-end credit — cardholders have a line of credit and the ability to make transactions up to the credit limit.
One of the keys to understanding credit cards is recognizing how your line of credit limits the spending power on your card. A portion of your available credit is used when you make transactions on the card. Unless you have a $0 balance, cardholders are expected to make at least minimum monthly payments each billing cycle.
Paying your credit card bills may replenish your available credit.
Typical Credit Card Requirements
Consumers typically need proof of identity and proof of income to become a credit card account holder. Credit card issuers may review your creditworthiness when determining whether to approve or deny your credit card application.
Some credit cards may offer 0% intro APR on purchases for several billing cycles or cash back rewards. You may compare credit cards and apply for the card of your choice.
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When to Choose a Credit Card
Depending on your circumstances, a personal loan may not be the right choice. A credit card can be a good option when you need a secure and convenient method of payment and are confident you can pay off your balance in the short term to avoid paying interest.
As a revolving loan, a credit card has no set terms, other than the minimum payment amount you must make each month. With a credit card, you can borrow as much or as little as you need up to your approved credit limit, and you only pay interest on the loan based on your account’s average daily balance. Some credit cards can also come with 0% APR introductory financing offers for new accounts.
That means you won’t begin incurring interest on your charges until the day they are made, and you can make payments against your balance at any time, and in any amount. All you have to do is make sure that you make at least the minimum payment each month on or before the statement due date.
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Pros and Cons of Personal Loans vs Credit Cards
When comparing a personal loan vs. credit card, it’s important to consider the benefits and drawbacks of each.
When is a personal loan better than a credit card? This chart highlights how either a personal loan or credit card can help you meet your goals and the pros and cons of an installment loan vs. credit card.
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Pros and Cons of Credit Cards
This table highlights some of the pros and cons of credit cards. (Learn more at How Many Credit Cards Should I have?)
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Personal Loan or Credit Card: Weighing Which One to Choose
Once you understand the advantages and drawbacks of each, it’s up to you to decide whether a personal loan or credit card will best meet your needs.
A personal loan can be a better choice when you are making a large purchase and want fixed repayment terms. A credit card, on the other hand, can be a better option when you occasionally need to finance smaller purchases, or are just looking for a method of payment that can sometimes be used as a loan.
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Alternative Funding Options
Even if you understand the difference between a loan vs. credit card, there are other funding options that may be worth considering. Below we highlight some alternative funding options you may consider:
- HELOC: A home equity line of credit, or HELOC, uses the equity in your home to secure a revolving personal loan, allowing you to draw funds as you need them. Just keep in mind you are putting your home up as collateral, which means you could risk losing it if you fail to repay the loan.
- 401(k) loan: You can also take loans from your 401(k) retirement plan, which is essentially making a loan to yourself from your own savings. However, there can be substantial penalties if you fail to pay it back on time or leave your employer with an unpaid loan. You’ll also be missing out on potential growth on those funds.
- Loans from friends and family: Friends and family can offer you personal loans. And while they may offer excellent terms without having to make a formal application, family loans can risk your relationships if not paid back.
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The Takeaway
As you can see, there are clear differences between credit cards and personal loans, as well as pros and cons to consider when weighing whether a personal loan vs. credit card is better for your financial situation. Make sure you understand the ins and outs of whichever financial product you choose and that you can afford to pay off any debt you incur to avoid negative consequences to your credit score.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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