Personal Loans vs. Credit Cards: An Overview
Personal loans and credit cards both offer a way to borrow funds and have 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, amount limits, and more. Mishandling either type of credit can undermine your credit rating, causing problems with loans, access to good housing, finding jobs
But beyond the similar attributes personal loans and credit cards share there are also key differences, such as repayment terms. Let's explore the definitions and differences between the two, along with some pros and cons of each.
- Personal loans offer borrowed funds in one initial lump sum with relatively lower interest rates; they must be repaid over a finite period of time.
- Credit cards are a type of revolving credit that give a borrower access to funds as long as the account remains in good standing.
- Credit scoring is a key factor influencing approvals and terms for both personal loans and credit cards.
- Personal loan and credit card agreements can be structured with a wide variety of provisions and terms.
Understanding Credit Scores
Before diving into comparing the differences between personal loans and credit cards, it’s important to understand one of the big similarities. 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 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 outstanding balances. Each individual is assigned a credit score based on this history that 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 for which they are approved.
Both personal loans and credit cards can be unsecured and secured, which also has an influence on the credit terms.
Both paying your credit card balance and repaying personal loans in a timely manner can help build your credit score.
Lenders offer a variety of options within the personal loan category that 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 ongoing access to funds like a credit card does. A borrower gets a lump sum up front and has a finite time frame to repay it in full, through scheduled payments, and retire the loan. This arrangement usually comes with lower interest for borrowers with a good to high credit score.
A personal loan can be used for many reasons. An unsecured loan can offer funds to finance large purchases, consolidate credit card debt, repair or upgrade a home, 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. Here are some pros and cons of a personal loan.
Generally best for large purchases like homes or cars
Usually offers a lower interest rate than a credit card
Provides funds in one lump sum
Typically includes a service fee and may have other fees that all add up
Property used as collateral, such as a car or home, can be seized if you don't repay in a timely manner (secured loans)
Keep in mind 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 origination fee and may have other fees as well.
Line of Credit vs. Loan
A distinction worth pointing out is the difference between a line of credit (LOC) and a loan. Unlike a loan, a line of credit has built-in flexibility—its main advantage. A disadvantage is that it typically comes with higher interest rates.
A LOC is a preset loan amount, but borrowers don't have to use it all. A borrower can access funds from the line of credit at any time as long as they do not exceed the credit limit terms and other requirements, such as making timely minimum payments.
A LOC can be secured or unsecured (most are the latter) and is typically offered by banks. A major exception is a home equity line of credit (HELOC), which is secured by the equity in the borrower's home.
Credit cards fall into a different class of borrowing known as revolving credit. With a revolving credit account, the borrower typically has ongoing access to the funds as long as their account remains in good standing. Revolving credit card accounts can also be eligible for credit-limit increases on a regular basis. 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 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. The best credit cards can include 0% introductory interest periods, balance transfer availability, and rewards. On the other end of the spectrum, some can come with high annual percentage interest rates 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.
Ongoing revolving credit balance that only charges interest when funds are used
For those with good credit, cards with 0% introductory interest rates, grace periods, and rewards
Accounts in good standing typically eligible for credit limit increases on a regular basis
For those with limited or poor credit, ability to build up to better credit terms over time
Interest typically higher than personal loans
Interest and fees can add up
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.
If you've found yourself stuck with a costly card and are looking for something with a lower interest rate, there are several cards currently available that are ideal for anyone looking to transfer their balance.
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 personal loans and credit cards there can also be other credit products for consideration. Here are some examples:
Business Loans and Credit Cards
Business loans and business 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 are offered with extremely high interest rates. Borrowers use employment pay stubs to obtain advances in cash. Payday loans can be considered predatory loans due to their reputation for extremely high interest and fees.
In general, credit can be a risky business that 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.
The Bottom Line
Not all credit is the same. Personal loans and credit cards can be structured with a wide variety of provisions and terms. Personal loans have relatively lower interest rates than credit cards but must be repaid over a set period of time. Credit cards provide ongoing access to funds and you only pay interest on outstanding balances that aren't paid off in a timely manner.
Regardless of whether you choose one or both, your credit score is key to getting approval and favorable terms. When it comes to the former, a personal loan calculator can help you better understand how your credit score will affect your monthly payments.