When consumers are short on money, they often turn to credit cards or personal loans for a cash infusion. Credit cards, which are small plastic cards issued by a financial institution or payment provider like Visa or MasterCard, offer a line of credit that can be used for purchases or consolidating debt. As long as you pay your statement, or the money you borrowed, within the grace period of 25 to 30 days, you generally won’t have to pay interest or other fees.
However, if you carry the balance and have cash flow problems, you may find yourself in debt and struggling to pay it off due to accruing interest. High debt levels can damage your credit score over time, as lenders don’t like to see borrowers with a high credit utilization — that is, a high level of debt in relation to the total amount of credit extended to them. So with credit cards, it’s important to make regular payments on time in order to avoid the debt trap and keep your credit in good shape.
Credit cards fall under the category of revolving debt, meaning there is a limit to how much you can put on your card (typically determined by your credit issuer). Credit cards are also unsecured loans, which indicates they aren’t backed by collateral like a home equity loan and tend to carry higher interest rates.
As with credit cards, personal loans can help you cover a large expense or consolidate debt. But in most other ways they are different. Personal loans can be secured or unsecured, depending on whether they’re backed by collateral. And personal loans give borrowers a lump sum upfront with specific guidelines for repayment. For example, a personal loan requires a credit check, and installment loans typically come with a fixed repayment term of two to five years. They also tend to carry a fixed interest rate, so you’ll receive a lump sum and pay the money, along with interest, in monthly installments.
In this article, we’ll highlight the pros and cons of a personal loan versus a credit card with regards to how it may impact your credit.
You carry these little plastic cards in your wallet, making it fast and convenient to pay by credit card. And if you have a credit card with a large enough credit line, you increase the odds that you can charge the full amount of a large ticket item on one card. But there’s more you should know about credit cards.
Low rates with good credit. If you use a card with a low introductory rate on new purchases, you may pay very little interest on the purchase for several months. You will need good credit to qualify for a credit card with a special low teaser rate. (Not sure where your credit stands? You can view two of your credit scores for free on Credit.com. Checking your credit will not harm your scores in any way.)
Ability to earn rewards. Many credit cards offer rewards just for spending as you normally would on things like groceries, dining, gas and retail. These can be a boon to your wallet, and if you make your payments on time, help you build up rewards to put toward everyday purchases. Travel rewards cards are another type of reward card that can give you cash back just for spending on hotels, airfare and car rentals. Just remember to pay off your balance so you don’t lose your rewards to high interest or fall into debt.
A big charge could hurt your credit scores. Charging a big expense on a low-interest rate credit card may save you more money upfront, but it could hurt your credit score in the long term by increasing your credit utilization. Let’s say you charge $5,000 on a credit card with a $10,000 limit, and you carry the balance rather than paying off most or all of it. By doing so, you are utilizing 50% of your credit line. Consumers with the best credit scores use 30%, and ideally 10%, of their credit lines.
Variable rates. Credit card rates are variable, so the amount you are charged for maintaining a balance may change over time. If you have trouble keeping up with your monthly payments, this could pose a real threat to your budget.
With a personal loan, you are charged a fixed interest rate for a fixed repayment period, typically two to five years. Paying off a personal loan is a steady and predictable way of paying for a big expense.
Good for budgeting. Once you qualify for a personal loan, you select a loan term and monthly payment amount that fits your budget. And if you choose a loan with no prepayment penalties, you can pay ahead if you wish.
No impact on credit utilization. Personal loans are viewed differently than credit card accounts by many credit scoring models. If your personal loan is listed as an installment loan rather than revolving credit, it will not be counted in your credit utilization ratio.
Loan inquiries lower credit scores. Applying for a personal loan will be counted as an inquiry into your credit, and this will lower your credit score a little bit. It’s a good idea to avoid shopping around for a loan by applying for several loans at the same time. Instead, you can ask a potential lender for the minimum credit score they require. It’s a good idea to check your credit scores before you apply, and try to select a lender with credit requirements you are likely to meet.
Interest rates can be high. If you take out an unsecured loan, you could be hit with a seriously high interest rate. That’s because in order to offset the risk of lending you money, lenders tack on additional fees or other charges. If you’re pressed for cash, applying for a loan with a high interest rate may not be the best option.