At some point in their lives, most people will find themselves in a situation where they need to pay for a large purchase, but lack the funds to cover it. Paying for these expenses in cash may be the best financial decision — but it isn’t always realistic. Whether it be for a home repair, medical bills, starting a small business or a new computer, there are times when you simply do not have the money to pay for major expenditures. In these situations, is it better to use a credit card or a personal loan?
What is a personal loan?
A personal loan is a loan that you can use for just about anything, from a vacation to medical expenses to debt consolidation. When you take out a personal loan, you receive the full amount of the loan. You then make fixed monthly payments for the time period specified in the loan, usually from two to five years. Most personal loans have fixed interest rates, and there usually is not a penalty for paying off the loan early. For secured loans (i.e., loans where you put up collateral, like a car), interest rates may even be lower than credit card rates. Unsecured loans will typically have a higher interest rate, but these rates may still be lower than those offered by credit card companies.
When should you use a personal loan instead of a credit card?
When deciding whether you should use a personal loan or a credit card for a major expense, the answer lies in the details: how big the purchase is, how long it will take you to pay off the amount, and the interest rates and fees charged by the lender or credit card company.
Many credit cards offer attractive zero percent interest rates, but only for an introductory period (often 12 to 15 months). If you are making a smaller purchase that you can pay off within this time frame, then taking advantage of one of these offers may be the best choice for you. For example, if you have to buy a new washer and dryer for a total cost of $1,000, and can pay that amount off in under a year, then opening a new credit card with a zero percent interest rate is likely the smart choice.
However, if you need access to a larger amount of money and will need more time to repay it, then a personal loan may be the smartest option. The interest rate for a personal loan will likely be lower than a long-term credit card interest rate, particularly if the loan is secured. Over time, a personal loan with a low interest rate will likely cost you less and be the better financial choice. Remember to carefully review loan terms, including any origination fees (a one-time fee based a percentage of the total loan amount), before choosing a lender. If possible, go with a highly rated finance company.
Another major consideration is how much you can afford in terms of your monthly payment. Most people don’t realize that only paying the minimum monthly payment on your credit card could cause you to take up to ten years to repay the balance in full!
When faced with a major expenditure and a cash shortfall, think carefully about the best option. Credit cards are better for short-term debt that can be paid off relatively quickly, while personal loans are better for larger amounts that need to be paid off over a longer period of time.