The options available to pay for a large purchase can be overwhelming. Even if you aren't actively looking for a financing option, you're probably getting credit card offers in the mail, seeing online ads, and hearing from local financial institutions about their great rate on a specific type of loan.
If you're unable to pay cash for an out of the ordinary expense – whether it's an emergency, a home improvement project, a wedding, or other unique expense – you have two main options for financing it: a personal loan or a credit card.
Credit cards provide you with a certain credit limit, and as you make payments, you're able to spend up to that limit again. This is considered ‘revolving credit.' You generally don't have a set term in which your balance must be paid off, and you don't have a previously agreed upon payment amount.
With a personal loan, you receive a set amount of money and pay that back over an agreed upon term by making payments of an agreed upon amount. Both personal loans and credit cards usually charge you interest, which is considered somewhat of a payment to the company loaning you money for allowing you to borrow from them.
Both credit cards and personal loans involve an application that will examine your credit score. Having bad credit doesn't necessarily mean you won't be able to get a credit card or a loan, it just might mean you'll pay a higher interest rate or have more restrictions. If you'll be paying a high interest rate, it might be in your best interest to reevaluate how necessary the expense is at this time. If it's possible to wait six months or a year, save up some money towards the expense to lower the amount you need to borrow, and work on improving your credit score. It could pay off for you long term.
How do you decide whether a credit card or a personal loan is the right decision for you? Consider the following six factors to help you make that decision.
How much do you need to borrow?
Many lenders will only offer personal loans for a minimum of $1,000. Some credit cards may have a lower credit limit than the amount you could get a personal loan for. When starting to research what your best option is, be sure you're only looking at options that would actually be able to provide you the amount you need to borrow.
Can you provide collateral?
Some financial institutions either require collateral to secure a personal loan or will give you a better rate if you apply for a secured loan as opposed to an unsecured. This provides extra peace of mind for the financial institution because providing collateral means you're agreeing the bank can take ownership of whatever you provide as collateral should you not pay the loan back. The financial institution will get their money one way or another, so they can be a little more flexible in lending to you if you've got something to secure the loan with. It provides them with significantly less risk.
Collateral can be a variety of different things: a vehicle, an investment, a life insurance policy, or even future paychecks. If your credit score isn't in great shape, you would likely be asked by many financial institutions to provide collateral for a personal loan, should you choose to apply for one.
One-time expense vs. an uncertain amount over a period of time
Maybe you're temporarily laid up, healing, and unable to work for a while following a surgery, or maybe your family is moving and you're expecting a gap between employment. Perhaps you're starting a home improvement project and aren't sure how much it will cost to complete. If you know you're going to have multiple, smaller expenses over a period of time and you predict you will be able to pay them off before the credit card payment is due each month, a credit card is probably the right decision for you. If you can pay the balance off before the payment is due, you will avoid paying interest..
If you're looking to make one transaction – a major car repair, paying off an emergency room or vet bill, an old used car purchase for your teenage child, or paying a contractor for a large home renovation – and you know it will take you some time to pay it off, a personal loan might be better for you.
Which option can offer you the best rate?
Some financial institutions offer great special rates in efforts to boost up their lending in certain areas. Shop around, both locally and online, to see if there's any special lending rates available that you would qualify for. Both your credit and the type of loan you're looking for can affect the rate you receive, so call or go in and visit with a lending officer instead of assuming you'll automatically get the shiny advertised rate.
Similarly, some credit card companies will offer special deals as well. They might offer no interest for a length of time, or lower interest rates. Just be sure you can pay your purchase off within the time frame the deal is good for. Zero percent interest is great until the fifteen months is up, you haven't paid the purchase off, and suddenly you're paying a significantly higher interest rate than you would have been paying on a personal loan.
As always, be sure to read the fine print on any special deals or rates to make sure it's actually the most cost-effective solution for you. Find out what fees are associated with closing on the personal loan you're considering, or be sure you know what the annual fee is for the credit card you're looking at. Not much is worse than thinking you're saving yourself money only to find out you actually ended up paying more in the long run.
Are life changes ahead?
No one knows the future, of course, but if you're planning an expensive life change that will lead to changes in your income, even if just temporarily – a new baby, a cross-country move, a job change, going back to school – it might not be the best time to add a loan payment into your budget.
If you need to make the purchase, this might be a situation where a credit card is a better option for you as you can make varying payments over time, as long as you're making the monthly payment on time. Ideally, you'll be able to pay more than the minimum payment because this situation will be the most expensive for you long term. If you're in a situation where you have to make the decision to pursue this option, try to find a 0 percent interest offer to minimize the long term effect this can have on your finances.
How financially disciplined are you?
Would getting a new credit card be a temptation that would put too much strain on your wallet? A credit card can be a great resource to have, but it can turn dangerous and expensive really quickly without some serious financial discipline. This will require some honesty with yourself, and ideally someone you trust who can hold you accountable.
If you're concerned a credit card might be too tempting for you and you might find yourself in over your head, a personal loan might be a better choice. You'll be able to borrow a specific amount of money to meet your financial need and not face the temptation to keep charging more items as you pay the balance down.
The bottom line
When it comes down to it, there's no blanket, set in stone, correct answer for whether a personal loan or a credit card is the right solution at any given time. Your financial situation is unique, and it will take some research to determine what the best solution is for your financial needs. You know what will work best for you and what your budget can handle, so it's up to you to determine which one fits your situation.
Spend some time doing that research, and don't be afraid to ask for help. If you don't understand something or want to be sure you aren't missing something important, reach out to a lending officer at your financial institution or call the credit card company.
Making the decision to borrow money, whether out of necessity or desire, can have a negative effect on your finances for many years if it's not handled wisely. Respect your future self by putting in the effort to make a wise financial decision now.