If unexpected expenses can derail your finances, you’re not alone. According to a study by the Federal Reserve, only 63% of adults said they had the funds to pay an unexpected $400 expense without going into debt. The rest — more than two in three Americans — would have to put that expense on a credit card that they couldn’t pay off in the next billing cycle, or would have to borrow the money some other way.
And that comes from a survey taken in 2019, before the pandemic wreaked havoc on the economy.
If you’re in a similar situation – either you don’t have enough savings to cover your financial emergency, or you don’t want to touch the money in this account – two options to consider when you have a big expense to cover are a personal loan or a credit card. A personal loan can also be a good idea when you want to consolidate your debts into one payment, with lower interest.
There are key differences between the two, as well as pros and cons for each choice.
When to use a personal loan
A personal loan can be obtained from a local bank or credit union, or from an online lender.
The funds can be used to pay for almost anything, although experts warn against unnecessary borrowing.
“Personal loans are commonly used for debt consolidation, which combines multiple payments, such as medical bills or credit card balances, into one monthly payment,” says Amy Vos, financial advisor at Northwestern Mutual. “Other common ways to use a personal loan include vehicle financing, small business financing, and home improvements.”
But a personal loan can be useful in a variety of other scenarios.
For example, it can be used in the event of an unexpected breakdown – your house needs a new roof, your car needs a new engine, or you have a medical emergency that insurance doesn’t cover. A personal loan can also be used to pay tuition fees if you do not qualify for a student loan or there is a delay in receiving funds.
Advantages and disadvantages of a personal loan
There are several advantages to taking out a personal loan. For example, if you consolidate your debts, you no longer have to meet several different deadlines.
“Combining multiple payments into one monthly payment simplifies and organizes your finances,” says Vos. However, this only makes sense if the interest rate on your personal loan is lower than the interest rate on your current debt.
Since personal loans are repaid in fixed, regular installments, they can provide consistency, which is important if you’re trying to manage a budget.
“Unlike a credit card, the payment is the same rate every time,” Vos explains.
You might also end up paying less. “Personal loans can have lower interest rates than many credit cards, but also a higher borrowing limit,” says Leslie Tayne, founder and chief counsel of Tayne Law Group, a law firm specializing in helping people. out of debt. So if you transfer high-interest credit card balances to a low-interest loan, you could save thousands of dollars, depending on the loan amount.
Also, if you have sufficient credit, you can get an unsecured personal loan, that is, a loan without collateral, such as your car or other valuable asset.
However, there are also downsides to getting a personal loan. If you don’t have good credit, it will be difficult to qualify for a low-interest personal loan, warns Tayne. The interest on a personal loan if you have bad credit can be as high as a high interest credit card.
“There are also fees to consider with personal loans, such as origination fees that go towards processing and repayment penalties that are charged if the loan balance is paid off early,” says Tayne. (Not all personal loans have prepayment charges.)
You might also have higher monthly payments than with a credit card, because the loan usually has to be paid off in a relatively short period of one to five years.
When to use a credit card
Credit cards are perhaps the most popular form of debt in America. In 2020, there were 497 million credit card accounts in the United States, according to Experian.
The consumer credit reporting company also noted that the average credit card limit in 2020 was $30,365 and the average credit card balance was $5,315.
Credit cards can be used to pay for almost anything. They can be replaced in just about any scenario in which a personal loan would apply.
Credit cards with a 0% APR introductory period are essentially an interest-free loan, but you’ll need decent credit to be approved for it – and a plan to pay it off before the period expires. of introduction.
Advantages and disadvantages of credit cards
When time is critical, applying for a credit card can lead to a line of credit being approved much faster than getting a personal loan. “It’s an incredibly fast approval process,” says Justin Goldman, co-founder and CEO of RenoFi in Philadelphia. You can’t know in advance what credit limit a new card will have, although applicants with better credit scores are usually approved for higher limits.
That quick approval, which can put the ability to spend thousands without paying later in your hands in days, can be dangerously tempting — and credit card balances can have high interest rates, too. “If you plan to pay it off quickly, the high interest rate may not be a big deal in the short term,” Goldman says.
The interest rate for a credit card (as well as a personal loan) will depend on your credit score, and if it’s good, you might qualify for a card with an introductory rate of 0%. A card with an interest-free introductory period allows you to defer payment for a year, sometimes longer.
“If you can find a credit card that allows for an initial 12 month interest-free period and you can afford to pay off the project for those 12 months, credit cards may be a valid option,” says Zachary A. Bachner. , CFP, advisor at Summit Financial in Sterling Heights, Michigan.
You can also get credit cards tailored to your interests and lifestyle preferences, which give you bonus rewards for spending in certain categories, such as meals, groceries or gas. You can then use those rewards – cash back, points or airline miles – to offset the cost of certain purchases or to travel for free.
“If your credit card offers cash back on purchases, rewards points, and/or frequent flyer miles, it might be a good idea to use that to reap the benefits,” Tayne says.
“A credit card also provides protection against fraudulent charges on your account,” says Tayne. Another benefit of credit cards is that making regular, on-time payments can boost your credit score, she adds.
A major downside of credit cards: fees.
Many credit cards have annual fees, which can exceed $500 for some high-end travel rewards cards. If you use a credit card to get a cash advance from an ATM or bank — money you would borrow against the card’s credit limit — you’ll also have to pay a cash advance fee. , which could reach up to 5% of the amount withdrawn. On top of that, the interest charged on this cash advance is usually higher than the interest on card balances.
Also, if you miss a credit card payment, you’ll have to pay a late payment fee, although many credit card companies can waive the fee the first time you’re late, if you ask. And if you exceed the card’s credit limit, you may be charged an overlimit fee, unless your account is set up to decline the transaction if it exceeds your limit.
Even cards with a 0% APR introductory period that allow you to transfer interest-bearing balances from other cards will charge you a fee to do so. These balance transfer fees can be up to 5% of the transferred amount.
Credit cards are also quite expensive to use if you don’t pay off your balances every billing cycle. According to the Federal Reserve, the average credit card interest rate is 14.65%. Applied to the average balance carried by Americans on their credit cards, which is around $5,300, this means that the average card customer would pay $800 each year to carry that balance – and that’s if the balance n not increase, which would result in a higher Interest Payment.
Even if you get 0% introductory rate, when the introductory period is over, the rate skyrockets. And if you make late payments or go over the limit, credit card companies can charge up your interest, in what’s called the penalty APR.
The lure of rewards can also cause people to spend more than they can afford. “If you use your card to get rewards and then pay off your balance every month, that’s great,” Vos says. However, if you keep a balance each month and pay interest on it, you’re likely negating the savings from your rewards.
Alternatives to personal loans and credit cards
Besides a personal loan and credit cards, there are other options to choose from.
- Peer-to-peer lending provide money to investors rather than traditional lenders and do not require perfect credit.
- Life insurance loans allow you to borrow money accumulated from certain life insurance policies. A life insurance policy can also be used as collateral for a bank loan.
- 401(k) Loans do not involve any application or approval process. But since you’re borrowing money when you retire, it’s a last resort, and we don’t recommend it, except in certain limited cases.
Personal loans and credit cards can provide funds when you are in need or don’t want to dip into your cash reserves. However, you will need a good credit rating for a personal loan and a clear understanding that credit cards work best when you avoid carrying a balance.