Personal Loan vs. Credit Card: Which is a Smart Option for You

Birch Finance

Choosing between a personal loan and a credit card is crucial, especially as debt levels rise. By the end of 2023, credit card debt reached a record $6,360 per borrower, up 10% from the previous year. 

Personal loans are also growing, with about 9% of U.S. adults owing an average of $11,692, largely due to high-credit consumers securing larger loans. 

Moreover, 36% of Americans have more credit card debt than emergency savings, highlighting the importance of thoughtful financial planning. 

This article examines the differences between personal loans and credit cards, providing insights to help make informed decisions for long-term financial health.

Personal Loan vs. Credit Card: Key Differences

Feature

Personal Loan

Credit Card

Type of Credit

Installment

Revolving

Security

Can be secured or unsecured

Can be secured or unsecured

Repayment Terms

Known end date for repayment

Flexible; perpetual if minimum payments are made

Interest Rates

Generally lower

Typically higher, but can be 0% with introductory offers

Rewards

None typically offered

Often includes rewards programs

Usage

Best for large, one-time expenses

Ideal for ongoing, everyday purchases

Debt Consolidation

Can consolidate other debts

Balance transfer options may consolidate credit card debt

Credit Impact

Fixed payments can improve credit score if managed well

Utilization ratio and payment history strongly impact credit score

Collateral

Some loans may require

Generally not required, except for secured credit cards



Personal loans are installment credits with fixed payments and lower interest rates, ideal for large expenses and consolidating debt. They can be secured or unsecured and improve credit scores when managed well. 

Credit cards are revolving credits with flexible repayment terms and potential rewards, suited for ongoing purchases. They impact credit scores based on utilization and payment history. 

What is a Personal Loan?

A personal loan is a form of installment credit that provides the borrower with a lump sum of money upfront. This type of loan is often used for a variety of financial needs and objectives, including but not limited to:

  • Debt consolidation: Combining multiple debts into a single payment.
  • Home renovations: Funding improvements or repairs.
  • Medical expenses: Covering healthcare-related costs.
  • Major life events: Financing weddings, funerals, or education.
  • Big purchases: Buying appliances, furniture, or electronics.

According to Investopedia's 2023 survey of 962 personal loan borrowers, the primary reason for securing such loans is debt consolidation, followed by home improvements and major purchases. The survey was conducted from August 14 to September 15, 2023, to explore how consumers manage and utilize personal loans.



Key Features

  • Fixed Interest Rates: The average rate is around 12.18 percent, according to a Bankrate study. This can vary based on individual financial profiles.
  • Set Repayment Terms: Typically up to 60 months, with some lenders offering extended terms.
  • Loan Amounts: Range from $600 to $100,000, often unsecured, meaning collateral isn't required.

Spencer Betts, CFP and financial advisor at Bickling Financial Services, explained in an interview with CBS News, “The rate for a personal loan is normally higher because there is no asset or collateral for the loan." He highlighted that loans secured by assets generally offer lower interest rates compared to unsecured personal loans.

Pros and Cons

Pros:

  • Predictable Payments: Fixed interest rates lead to consistent monthly payments.
  • Versatility: Can be used for a wide range of personal needs.
  • Debt Consolidation: Can potentially lower overall interest payments by combining high-interest debts.
  • No Collateral: Most are unsecured, not requiring assets as security.

Cons:

  • Interest Rates Vary: Rates are contingent on creditworthiness, potentially higher for those with poor credit.
  • Fees: Origination fees and prepayment penalties may apply.
  • Debt: Incurring more debt, especially if used for discretionary spending rather than financial improvement.
  • Credit Requirements: Typically require a good credit score for the best rates.

What is a Credit Card?

A credit card is a financial tool that offers access to a revolving line of credit. Unlike loans that provide a fixed sum of money, a credit card gives you the flexibility to borrow money as needed up to a certain limit, making it a convenient option for various transactions:

  • Routine Purchases: Groceries, gas, and daily expenses.
  • Emergency Funds: Unplanned expenditures like car or home repairs.
  • Online Shopping: E-commerce and in-app purchases.
  • Travel Expenses: Booking flights, hotels, and rental cars.
  • Reward Maximization: Taking advantage of cashback and points on eligible purchases.

Josh Miller, who leads consumer acquisition, marketing, and product development for Deposits and Consumer Lending & Payments at KeyBank, noted in an interview with CBS News, "For small purchases, many retailers and merchants offer buy now, pay later (BNPL) options for clients that often come with 0% interest or in some cases low payments that fit a person's budget." He emphasized the availability of convenient payment alternatives offered by various retailers.

Pro Tip: Credit card companies impose interest only when you maintain a balance month-to-month; paying in full each month effectively grants you a free short-term loan. By consistently clearing your balance and using a rewards card for all purchases, you can enjoy benefits without accruing interest. 

However, discipline is crucial to avoid overspending, as the costs from interest can quickly surpass any rewards gained.

Key Features

  • Revolving Credit: Use funds up to your credit limit; pay interest only on the amount you use.
  • Credit Limits: Average new credit limits range from $5,000 to $6,000.
  • Variable Interest Rates: The median rate is currently 24.37%.
  • Minimum Payments: Typically 2%-3% of the outstanding balance, affecting interest accrual and repayment time.

Pros and Cons

Pros:

  • Flexibility: Pay for items over time and manage cash flow.
  • Rewards: Earn points, miles, or cashback on purchases.
  • Building Credit: Regular use and repayment can improve credit history.
  • Emergency Access: Available funds in unexpected situations.

Cons:

  • High-Interest Rates: Can be costly if balances are not paid in full.
  • Minimum Payment Trap: Paying only the minimum can lead to long-term debt and high interest accrued.
  • Credit Score Impact: High utilization can negatively affect credit scores.
  • Potential for Overspending: Easy access to credit may encourage excessive spending.

Comparing Interest Rates and Fees

When comparing both personal loans and credit cards, a crucial aspect to consider is the cost associated with each, primarily driven by interest rates and fees. Personal loans often come with fixed interest rates, which currently average around 12.18%. That means the rate typically stays the same for the length of the loan. But it’s important to check the full details of any loan agreement to understand how interest works in that loan agreement.

In contrast, credit cards carry variable rates, with the median average sitting at 24.37%. That means they can increase or decrease based on something called index rates. But the Consumer Financial Protection Bureau (CFPB) says there are other times when a credit card’s APR could change—even if it has a fixed APR.

Understanding Additional Fees

  • Origination Fees for Personal Loans: These are one-time charges assessed at the start of the loan term. It is calculated as a percentage of the loan amount, typically between 1% to 6%. As such, it directly impacts the net amount received.

For example, a $10,000 personal loan with a 5% origination fee will net $9,500. Some lenders may add the fee to the loan balance instead, affecting the total interest paid over time.

  • Annual Fees for Credit Cards: This is a yearly charge for the privilege of using a credit card, not tied to usage. It varies widely, from $0 to several hundred dollars, often linked to the card's benefits. Note that premium cards with high rewards rates, travel benefits, or exclusive perks usually have higher annual fees. Some credit cards waive the annual fee for the first year as a promotion.
  • Late Fees:
  • Personal Loans: Late payment fees on personal loans are charged when a borrower fails to make a payment by the due date. The fee amount and the conditions under which it is applied can vary depending on the lender's policies and the terms of the loan agreement. Typically, late fees range between $25 and $50.
  • Credit Cards: Late payment fees for credit cards are similarly imposed when a cardholder does not make the minimum payment by the due date. Federal regulators introduced a new regulation that limits credit card late fees to a maximum of $8.
  • Foreign Transaction Fees: These fees are specific to credit cards and are charged when a cardholder makes a purchase in a foreign currency or through a foreign bank. The fee is typically a percentage of the amount of each transaction, generally ranging from 1% to 3%.

Case Scenarios

Personal Loan

Let’s say Mr. Ford took out a personal loan of $10,000 with an interest rate of 12.18% over a 60-month term, their monthly payment would be approximately $223.36.Throughout the loan, they would pay around $3,401.31 in total interest, making the overall cost of borrowing $13,401.31.

(source: Personal Loan Calculator)

Credit Card

Let’s say Mr. Ford has a credit card with a balance of $10,000 and an interest rate of 24.37%. The terms of his credit card require a minimum monthly payment of 2% of the balance or $200, whichever is higher. 

Initially, his monthly payment starts at $200. As he pays down the balance, the amount of each payment decreases because it's a percentage of the remaining balance. 

However, by only making the minimum payments, Mr. Ford could end up paying more than $14,000 in interest over the extended period it will take to pay off the entire balance, significantly increasing the total cost of his debt.

Impact on Credit Score

Personal Loans and Credit Score

Taking out a personal loan can have a multifaceted impact on your credit score. Initially, applying for a loan may cause a small dip due to the hard inquiry on your credit report. However, if managed well, a personal loan can diversify your credit mix and improve your score over time by adding a history of on-time payments.

Credit Card Usage and Credit Score

Credit card use plays a significant role in credit score calculations, especially in terms of credit utilization—how much of your available credit you're using. High utilization can signal risk and lower your score, while low utilization can be beneficial. Additionally, making timely payments is crucial; late payments can harm your credit score significantly.

Tips on Managing Credit

  • For Personal Loans:
  • Always pay on time to build a positive payment history.
  • Aim to pay more than the minimum to shorten the loan term and save on interest.
  • Avoid taking out multiple personal loans simultaneously to prevent a high debt-to-income ratio.
  • For Credit Cards:
  • Keep credit card balances low; aim to use less than 30% of your available credit.
  • Pay off your balance in full each month to avoid interest and improve your payment history.
  • Limit the frequency of opening new accounts to avoid multiple hard inquiries.

So Which is Better?

When to Choose a Personal Loan

  • Large, One-Time Expenses: For significant expenditures like home improvements or medical bills, a personal loan provides a lump sum with a lower interest rate.
  • Debt Consolidation: If you’re juggling multiple high-interest debts, a personal loan can combine them into a single payment with a lower rate.
  • Fixed Repayment Structure: Personal loans are ideal if you prefer the discipline of fixed monthly payments and a clear payoff date.

When a Credit Card is the Better Choice

  • Flexibility in Repayment: For those who value the option to pay off debt over time or who can pay off purchases quickly to avoid interest.
  • Rewards and Benefits: If you frequently take advantage of points, miles, or cashback, and can pay off the balance monthly, a credit card offers added value.
  • Small or Recurring Expenses: Credit cards are suitable for everyday purchases or costs that you can cover within a billing cycle to avoid interest.

Conclusion

In weighing personal loans against credit cards, we've explored their differences, costs, and credit score implications. Each option suits different financial situations and goals. As you consider your choice, evaluate your circumstances and future plans with precision. Let this understanding shape your decision, ensuring it aligns with your path to fiscal health.

Key Takeaways:

  • Personal loans generally offer lower fixed rates, making them cost-effective for large expenses and debt consolidation.
  • Credit cards provide flexible repayment options, while personal loans offer structured, predictable plans.
  • Timely payments boost credit scores; however, credit cards require careful utilization management to avoid negative effects.


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