We’d all love to be able to pay for all of our purchases out of pocket. Unfortunately, that’s not always possible. This is why loans are so helpful: They allow us to pay for purchases we couldn’t otherwise, all at once.
Two popular ways people borrow money are personal loans and credit cards. Both of these loans allow you to borrow money and pay it back over time. They’re both paid back on a predetermined schedule, and both have fees for late or missing payments. Personal loans and credit cards are offered by multiple types of lenders, with banks being one of the most popular.
Lenders will use information like your financial background, your credit score, and your credit report to determine how much money they’ll lend to you (and with what interest rate you must then pay it back). Depending on the type of loan you get, the amount borrowed will be given as revolving credit or a lump sum. You’re free to spend your loan as you see fit. It’s important to keep in mind, however, that loans can significantly impact your credit score. Mismanagement of loans can lower your score and make it difficult to borrow more in the future.
As similar as they are, personal loans and credit cards are different types of loans that should be used for different kinds of expenses. In order to know which of these loans is best for you, you must first understand how each type works.
A personal loan is a loan that you must be approved for and the money is given to you as a lump sum by a financial institution (i.e., a bank or a credit union). There are two kinds of personal loans: Unsecured and secured.
Unsecured personal loans are offered based on creditworthiness, or the likelihood that you will pay it back. Your creditworthiness is determined based on your credit history (how much credit you’ve had, what types of credit you’ve had, how successfully you’ve paid your credit off, etc.). It is best to have good credit in order to be approved for this kind of loan—this proves to a lender that you are likely to pay back your credit on time. It is much more difficult to get an unsecured personal loan if your credit score is low; it’s possible, but interest rates are usually higher for people with low scores.
Secured personal loans are not based on creditworthiness. Because of this, they are a little easier to get than unsecured personal loans. With this kind of loan, you use assets, such as a car or a savings account, as collateral. This means that a lender may be able to seize these assets if you default on payments. This incentive for you to pay back your loan on time gives lenders the security they look for in borrowers.
After deciding which type of personal loan you’d like to apply for, you’ll need to determine the amount of money you would like to borrow. The amount given in a personal loan can vary widely—it is determined on a case-by-case basis. According to Lendingtree, the average personal loan is $6382.
The interest rates offered on personal loans also vary. They depend upon the amount you’re borrowing, the timeline of your loan, and your credit worthiness.
After you’re approved for a personal loan, you’re given the money as a lump sum. You’ll be told the interest rate you’ll be charged and provided with a timeline on how long you’ll have to repay the loan. After this, you use the loan as you’d like, making fixed regular payments to pay it off. If you’d like another loan once you’ve finished paying off the first, you’ll have to go through the application process again.
Credit cards are also loans that require approval. They are given by financial institutions or credit card companies.
Unlike a personal loan, a credit card does not provide you with a lump sum of money. Rather, you’re given revolving credit. This means that as long as you continue to pay the amount of credit you’ve used, you’ll have the same amount of credit continually. This also means that you’ll have a credit limit. Every time you use your card, you are using a part of your limit; what you haven’t spent is the remaining credit limit. If you pay back the amount you’ve used, however, you’ll once again have all of your credit available to use.
Credit card companies determine your credit limit based on your credit report (a document detailing your credit history) and financial history. They decide your credit limit (rather than allowing you to do so) because this allows them to extend an amount that they believe you will realistically be able to repay.
This same method is also used to determine your interest rate. Interest rates are the amount charged on top of the principal by a lender. As with your credit limit, your financial information will be used to set your interest at a rate which you will reasonably be able to afford. As of June 2020, the average annual interest rate in the U.S. was 20.14%. This means that the average cardholder is paying about 20% of his or her limit to a credit card company in exchange for being able to use the loan.
Credit cards are also different from personal loans in that you don’t need to reapply for a credit card in order to increase your limit. Credit card companies may authorize you for a credit increase if your credit score increases, you’re making regular payments that are larger than the required monthly minimum, or you keep your balance below 30% of your available credit.
Personal loans and credit cards are different types of loans. As such, they should be used for different purposes.
Personal loans are best used for big one-time payments. Because a personal loan is a large sum provided all at once, it can be used to pay off outstanding debts or debts with higher interest rates (which could help improve your credit score). Personal loans can also be used for large purchases, such as a car, or to help pay medical bills. The most important thing, however, is that you’re able to make your payments regularly. Because your payment amount is agreed upon when you accept a loan, it’s important that you determine your ability to repay it based on the terms of the loans.
Credit cards, on the other hand, are best used for smaller, more frequent purchases. You can use your credit on regular expenses like groceries, shopping, or transportation. Since credit cards are based on revolving credit, you have the ability to pay off what you’ve used at any given time, putting your entire line of credit at your disposal once more. Before getting a credit card, you’ll need to make sure that you’re able to pay at least the required minimum monthly payment, or you’ll have to pay late fees, which on average, cost $36. However, you can also pay off your whole balance in advance to avoid having to pay interest.
Depending on your credit history and the purchases you’d like to make, one of these two types of loans may be more appropriate than the other. The most important thing to remember is to use these loans wisely and to your advantage. Doing so will help prove your creditworthiness to other lenders.