Oftentimes, consumers are faced with options when they need to cover an expense that can’t be paid for out of pocket. They typically have to rely on some form of credit to meet this expense. Two popular options are credit cards and personal loans. Both of these leave the consumer with debt; here’s a little more information.
What is a Personal Loan?
A personal loan is a form of unsecured debt, which means there is no asset that serves as collateral on the loan. Unsecured personal loans are risky for lenders because there is nothing they can claim and sell to satisfy the outstanding debt in the event of a borrower’s default.
When someone takes out a personal loan, the lender provides the borrower with cash for the entire loan amount. The borrower then makes monthly payments in order to repay the full balance of the loan. Interest rates for unsecured personal loans are typically higher than the interest rates on secured debt such as mortgages or car loans.
What is a Credit Card?
A credit card is a form of revolving debt. That means a financial institution extends a line of credit up to a maximum dollar amount to the cardholder. The cardholder can use any amount up to that maximum to make purchases and then makes payments based on the amount of credit actually utilized at any point in time.
Credit cards have what is called a “grace period” of about 25-30 days. What that means is the credit you use is essentially free for that grace period. If you pay off the full amount of credit you used within the grace period, there are no additional interest charges. If you don’t pay the full balance during that time, however, interest begins to accrue on your outstanding balance. Interest rates are fairly higher than other types of debt like a mortgage.
Personal Loans vs. Credit Cards: Similarities
Personal loans and credit cards are similar because they are both unsecured forms of debt. Neither has an asset that serves as collateral in the event of default. Credit cards and personal loans can both flexibly be used to pay for anything; you just need the available credit or a large enough loan.
Interest rates on personal loans and credit cards are both typically higher than the interest rates banks charge for secured forms of debt. The interest rates are higher because both personal loans and credit cards are riskier forms of lending for the issuing financial institution.
Personal Loans vs. Credit Cards: Differences
The major difference between personal loans and credit cards is the way the money is disbursed to the borrower. With a personal loan, the bank disburses the full amount of the loan in one lump sum payment to the borrower; it is paid off as installment debt. With a credit card, borrowers are extended a line of credit and can utilize whatever portion of that credit. In addition, credit cards allow you to continuously access your line of credit as you need it over time; they are considered revolving debt which is different from installment debt.
Another difference between personal loans and credit cards is the cost of borrowing. Credit cards have a variable interest rate, which means the actual interest rate the bank charges can change over time. As market interest rates increase, so do your credit card interest rates. Banks are also free to increase your credit card interest rate at any time if they re-evaluate your credit.
On the other hand, personal loans usually have a fixed interest rate for the term of the loan. That means the interest rate does not change, and your required payments also stay the same each month. In some cases, you can pick a variable rate on a personal loan.
As a general rule of thumb, credit card interest rates are usually higher than personal loan interest rates. However, personal loan rates can easily surpass credit cards, especially if the borrower has a lacking credit history.
There is one aspect of credit cards completely missing from personal loans. Credit card companies offer rewards programs for credit card holders who spend habitually. Your credit card purchase can earn you cash back, travel rewards, and other rewards points to use at a large number of retailers, as well as many other benefits.
Which is Better?
There is no simple answer to the question of which is better because it really depends on the situation and circumstances.
If you are making a large purchase and do not have the ability to pay off the balance in a very short period of time, a personal loan might be better choice. Lenders typically give you several years to pay off the balance, and the interest charges during that time are much lower than they are with a credit card.
If you are making a small purchase or can pay off the purchase amount within a couple of months, a credit card is probably a better option. Your interest charges will be relatively small, and you won’t have to go through the process of applying for a personal loan, which can require providing income documentation to the lender.
Author: Jeff Gitlen
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