Personal Loans vs. Credit Cards: An Overview
Credit. It's what separates us from the lower primates. With it, we're granted temporary access to borrowed money for which we can use to finance aspirations greater than if we were limited to just our own money. The lenders get interest and fees, the borrowers get leverage, and the economy usually gets help to grow. Without credit, capitalism would stagnate.
But not all credit is the same. Credit and credit agreements can be structured with a wide variety of provisions and terms. There are thousands of institutions in the business of lending money. So is it just a case of going to whoever offers the lowest rate? In general, that answer is usually no.
Before deciding on a loan there are several considerations. Comprehensively, one of the biggest considerations is whether to choose a personal loan or a credit card. Both offer many of the same standard credit provisions. In both loan and credit card agreements you will typically find funds offered from a lender at a specified interest rate, monthly payments that include principal and interest, late fees, underwriting requirements, principal limits, and more. However, beyond the many similar attributes personal loans and credit cards share there are also many differences. Here we will explore the definitions and differences along with some advantages and disadvantages that can potentially help to decide between the two.
- Credit agreements comprehensively can be structured with a wide variety of provisions and terms.
- Credit scoring is a key factor influencing credit approvals and terms for both personal loans and credit cards.
- Personal loans offer borrowed funds in one initial lump sum with relatively lower interest rates and must be repaid over a finite period of time.
- Credit cards are a type of revolving credit loan that gives a borrower lifetime access to funds.
Understanding Credit Underwriting
Before diving into comparing the differences between personal loans and credit cards, it’s important to understand one of the big similarities. Any type of credit is not always easy to obtain. The U.S. and most countries have integrated a credit scoring system that forms the basis for credit approvals. The three major U.S. credit bureaus, Equifax, Transunion, and Experian are the credit market leaders in establishing credit scoring standards and partnering with lending institutions to enable credit approvals.
Credit scores are based on a person’s past credit history, including credit defaults, inquiries, accounts, and balances outstanding. Each individual is assigned a credit score based on this history which heavily influences their chances for credit approval. Comprehensively, all of the factors considered by a lender can also influence the interest rate a borrower pays and the amount of principal they are approved for. Both personal loans and credit cards can be unsecured and secured as well which also has an influence on the credit terms.
Credit scoring is a key factor in determining credit approval and terms for both personal loans and credit cards.
Lenders offer a variety of options within the personal loan category which can affect the credit terms. In general, the main difference between a personal loan and a credit card is the long-term balance. Personal loans do not offer lifetime access to funds like a credit card does. A borrower gets a lump sum up-front and has a finite loan timeframe with payments that go towards paying off the loan in full and closing the account. This arrangement usually comes with lower interest.
A variety of lenders offer personal loans through both online and in-person applications. A personal loan can be used for many reasons. An unsecured loan can offer funds to finance large purchases, consolidate credit card debt, or provide funding to fill a gap in receipt of income. Unsecured loans are not backed by collateral pledged from the borrower.
Home loans, auto loans, and other types of secured loans can also be considered a personal loan. These loans will follow standard procedures for credit approval but they may be easier to obtain since they are backed by a lien on assets. In a home loan or an auto loan, for example, the lender has the right to take possession of your home or car after a specified number of delinquencies. Secured loans usually come with slightly better terms because the lender has ownership rights involved which reduces their default risk.
Keep in mind also, that interest is not the only expense to consider in a loan. Lenders also charge fees which can add to a loan’s total costs. Personal loans typically include an initial service fee and may have other fees as well.
Major Advantages and Disadvantages
+Can be best for large asset purchases like homes or cars.
+Can usually offer a lower interest rate on borrowed funds than a credit card.
+Provides funds in one up-front, lump sum payment.
+/-Is only open for a specified amount of time.
Credit cards fall into a different class of borrowing known as revolving credit. With a revolving credit account, the borrower typically has lifetime access to the funds as long as their account remains in good standing. Revolving credit accounts can also be eligible for credit limit increases on a regular basis. Revolving credit interest rates are typically higher than personal loans.
Revolving credit works differently than a personal loan. Borrowers have access to a specified amount but they do not receive that amount in full. Rather, the borrower can take funds from the account at their discretion at any time up to the maximum limit. Borrowers only pay interest on the funds they use over time so a borrower could have an open account with no interest if they have no balance.
Credit cards can come in many varieties and offer a lot of convenience. Top quality credit cards can include 0% introductory interest periods, balance transfer availability, and rewards. On the other end of the spectrum, some credit cards can come with annual percentage interest rates of 30% combined with monthly or annual fees. All credit cards can usually be used anywhere electronic payments are accepted. Top quality cards with rewards points can be highly beneficial for a borrower who utilizes the perks and pays balances down monthly. Rewards cards can offer cash back, points for discounts on purchases, points for store brand purchases, and points toward travel.
In general, credit cards can also be unsecured or secured. Unsecured cards offer credit with no collateral. Secured cards are often an option for borrowers with low credit scores. With a secured card, a borrower is required to provide capital towards the card’s balance limit. Secured cards have varying terms so some may match the secured balance, some may offer an increase after a specified amount of time, and some may apply the secured balance to the card as a payment after several months.
Overall, each type of credit card will have its own way of accumulating interest so it can be important to read the fine print. Unlike personal loans where your monthly payment is usually the same over the entire repayment period, a credit card bill will vary each month. Some credit cards offer borrowers the advantage of a statement cycle grace period which allows for freely borrowed funds. Other cards will charge daily interest, including the final interest charge at the end of the month. For cards with a grace period, borrowers can find that they have approximately 30 days to purchase something interest-free if the balance is paid before interest begins to accumulate.
Comprehensively, on the surface, financing with a credit card may seem like a simple option, but as with all borrowing, it is important to do your due diligence. Credit cards can offer a viable alternative to personal loans since they can be available with 0% interest and may offer some grace periods. Convenience and rewards points are also other advantages. However, as is the case with any credit borrowing, interest and fees can be a considerable burden.
Major Advantages and Disadvantages
+Lifetime revolving credit balance that only charges interest when funds are used.
+Conveniently accepted as a payment option nearly anywhere that electronic payments are accepted.
+0% interest, grace periods, and rewards that can reduce the burden of interest payments.
-Cash advance limitations.
Other Types of Credit Lending
In general, loans and revolving credit cards make up a substantial majority of the total credit market. However, beyond just standard loans and credit cards there can also be other credit products for consideration.
Margin: Margin borrowing is a type of borrowing available through an investment account. Investing platforms offer borrowing for investments with interest charged at a specified interest rate. Investors typically use margin borrowing because they expect to gain a profit from the investment even after paying the margin interest.
Reserve lines: Reserve lines have characteristics of both loans and credit cards. Institutions usually have higher underwriting requirements with a reserve line. Reserve lines are revolving credit accounts that are usually tied to a bank checking account.
Business loans: Business loans and credit cards can be an option for all types of businesses. Business loan underwriting usually involves analysis of financial statements and projections. Business credit cards can be somewhat easier to obtain and offer the same advantages as personal revolving credit cards.
Payday loans: Payday loans are offered with extremely high interest rates for borrowers who use employment paystubs to obtain advances in cash.
In general, credit can be a risky business which requires due diligence from the borrower. The nature of credit agreements can create an opportunity for predatory lending and lending fraud, so it is always important to understand credit terms and ensure that you are borrowing from a legally authorized organization in order to protect yourself financially.