Deciding between a personal loan vs. a credit card: Which is better?

Knowing when to take out a personal loan or when to use your credit card can prevent financial challenges down the road. They are both useful ways to handle an unexpected expense or a larger purchase, but there are some major differences in how you repay what you borrow.

If you need to take out a large lump sum of money for a project or want to pay off high-interest credit card debt, then you may want to consider a personal loan. A credit card is the better option if you’re making a smaller, everyday purchase.

Personal loans vs. credit cards

A personal loan provides a lump sum — less any origination fees, if applicable. You make fixed monthly payments until your balance is paid. Loans are typically used for a large expense or debt consolidation.

A credit card is a revolving line of credit, meaning you can repeatedly borrow funds up to a predetermined threshold called your credit limit. Because of this, a credit card is typically best for ongoing daily purchases.

Key differences between a personal loan and credit card

When comparing personal loans and credit cards, check repayment terms, interest rates and how you access your funds. These can be important factors that help determine which is better for the expense you’re paying for.

While there are many differences between a personal loan and a credit card to consider, there are also some important similarities. Both are a way to borrow money that you must pay back in monthly installments. Inconsistent or missed payments can damage your ability to borrow more in the future — or even qualify for housing or jobs.

When to use a personal loan

Personal loans tend to have lower interest rates than credit cards and are geared toward large, one-time expenses.

Taking out a personal loan makes the most sense when you know you can make the monthly payments for the full length of the loan. You can use a personal loan calculator to estimate your payments based on loan term and interest rate.

A few common reasons to take out a personal loan include:

• Consolidating high-interest debt
• Paying unexpected medical bills
• Completing home improvement projects
• Covering wedding costs

Unfortunately, there are times when the risk of using a personal loan could outweigh the potential benefits. Retail therapy, covering basic needs and expensive trips are not advisable.

Pros and cons of a personal loan

Knowing the pros and cons of a personal loan can help you make a well-informed decision before using this form of financing.

Pros

• Significantly lower average APR
• Good for debt consolidation
• Consistent monthly payments

Cons

• No rewards, points or other benefits
• Multiple fees
• May have strict eligibility requirements

How personal loans affect your credit

Depending on how you use a personal loan, it can have a positive or negative impact on your credit score. When you apply for a loan, a hard inquiry will be placed on your credit report, which can temporarily decrease your score by up to four points. It will remain on your credit report for up to two years but won’t impact your score after 12 months.

However, if you pay your loan back on time, it could improve your credit score as payment history counts for 35 percent of your credit score. Using a personal loan to consolidate high-interest debt will also lower your credit utilization ratio — which makes up 30 percent of your credit score — and could improve your credit in the long term.

Who a personal loan is best for

If you have good to excellent credit and need to refinance high-interest debt, using a personal loan may be a wise financial choice. A personal loan offers consistent payments and may be available at a lower interest rate than your current debt, which can save you hundreds of dollars or more.

A personal loan can also help pay for an important expense that can’t be saved up for, like home renovations or wedding costs. Using a personal loan instead of a credit card will likely involve less interest, so it can be useful if you know exactly how much you need and don’t want to carry a balance on your card.

When to use a credit card

Credit cards have rewards systems for frequent use, which makes them good for responsible everyday spending.

When it comes to credit card usage, paying your balance off in full at the end of the billing cycle is critical for your financial health. If you don’t pay your balance, and your card doesn’t have a 0 percent introductory rate period, interest will accrue. If you only make minimum payments, you could spend a long time paying off the balance.

Because of this, you should only use your credit card for purchases you’re certain you can pay off in a reasonable amount of time.

A few ways you could use your credit card include:

• Making smaller everyday purchases
• Paying for a well-planned vacation
• Earning cash back or vacation points
• Taking advantage of a 0 percent interest opportunity

On the other hand, a credit card may not be the best idea for paying off loans, making large purchases or covering expensive unexpected bills, such as medical costs.

Pros and cons of a credit card

When used responsibly, a credit card can be a great way to earn rewards, cash back and travel benefits. However, a credit card also has the potential to negatively impact your financial health. In fact, credit cards have a variety of pros and cons:

Pros

• Earn rewards and bonuses
• Boost your credit rating
• Convenient for everyday expenses

Cons

• High interest rates
• Potential for overspending
• Multiple associated fees

How credit cards affect your credit

If you pay your credit card off on time each month, you will build up a history of on-time payments and can increase your credit score over time. And if you have long-established lines of credit cards that have been open for several years, you may get a boost on your credit score — length of credit history counts for 15 percent of your FICO score. This is particularly true if you have consistently maintained the accounts in good standing.

However, late payments of 30 or more days past due can damage your credit. Also, keeping a high balance on your card can lead to a high credit utilization ratio, which lowers your credit score. It’s typically a good idea to keep this ratio below 30 percent if possible.

Personal loan and credit card alternatives

Personal loans and credit cards aren’t the only ways to access funds. Home equity loans, lines of credit and cash advances may also be useful ways to cover big expenses.

• Home equity loan: A home equity loan allows you to borrow a lump sum of money by using the equity of your home. You can use a home equity loan for a number of reasons, including home improvement projects and debt consolidation.
• HELOC: A home equity line of credit (HELOC) also uses your home’s equity, but it works more like a credit card. With a HELOC, you’re given a line of credit and can take out how much you need when you need it. They are best for ongoing home improvement projects or expenses.
• Personal line of credit: Similar to a credit card, a personal line of credit is a type of personal loan that offers more flexibility. You can draw from the loan as you need it, and you’ll pay the balance back with interest. Common uses of a personal line of credit include funding unexpected expenses and major purchases.
• Cash advance: Many credit card issuers offer cash advances, which allow you to withdraw cash against your credit card limit. The interest rate charged for a cash advance is typically higher than the interest charged for purchases, so always check before withdrawing.

The bottom line

While a credit card is good for getting rewarded for everyday purchases, it can lead to more debt if you outspend your budget. It works the same way with a personal loan. Before you decide whether a personal loan or credit card is right for you, explore all of your options and compare rates and fees for each product by getting prequalified.

And keep in mind that using both is an option. For example, you may decide that you want to get a personal loan for a one-time purchase and apply for a credit card for regular spending.