Personal loans vs. credit cards
The basics of personal loans
• Personal loans are unsecured debts.
• Usually are paid off in two to five years.
• Interest rates are often lower than credit cards.
• Can be a good option for large, one-time purchases.
When an expense crops up, most people pull out their plastic and put the charge on a credit card, but there is another option. A person with good credit and a solid income also can opt to take out a personal loan.
Personal loans, like traditional credit cards, are unsecured loans. They aren’t like auto loans and home mortgages that are secured by the property which can be seized by the creditor if the borrower defaults on the payments.
There are pros and cons to obtaining a personal loan, however.
Unsecured loans aren’t backed by property, so creditors are making a bet that the borrower will repay the loan based on their credit history and income.
A personal loan usually carries a much higher interest rate than a loan secured by property. The interest rate on a personal loan is often lower than a high-balance credit card. It also can be higher, so comparing lenders is beneficial.
One potential advantage to a personal loan vs. a credit card is that the former usually comes with a fixed rate. The borrower typically makes regular monthly payments that cover the interest and principal on the personal loan, which normally pays off in two to five years.
By contrast, most credit cards come with adjustable rates, and the interest charges are more unpredictable. A person can more easily create a budget that will pay off the personal loan. It can be much more challenging to pay off multiple credit cards with revolving, adjustable-rate balances.
Drawbacks of personal loans
There can be downsides with personal loans, however. People commonly take out unsecured personal loans to pay off existing credit card balances, but that can be a perilous approach if not handled well.
One problem is that the borrower may not realize that much interest-rate savings with a personal loan. The interest on a personal loan can actually be higher than some credit cards, especially those cards featuring special offers. Keep in mind that unsecured personal loans tend to carry a higher interest rate because the risk to the lender is higher than when the borrower puts up a car or house as collateral.
In a more general sense, it is financially risky to take out a loan to wipe clean your credit card debts, according to credit counselors. Essentially, you are just parking your debt in another location. This approach zeros out the credit card balances. Once your credit cards are freed up, you may be tempted to go on another spending spree that will put you in a deeper hole.
Most credit counselors say it doesn’t make sense to take out a personal loan if the purchase is relatively small, and the debt could reasonably be paid off within a short period. Many credit card companies, for example, offer teaser interest rates that are low, or even at 0 percent, for several months. In the case of a modest purchase that can be paid off quickly, it may make more sense to put the charge on one of these cards.
A personal loan could be the better choice if you are planning to make a one-time, large purchase and pay it off over a longer period, however.