If you find yourself in a situation where you need a little financial help, take the time to think about your options. Automatically reaching for a credit card – or applying for a personal loan – might not be the best money exchange.
According to the Federal Reserve Consumer debt rose $ 12.3 billion month-on-month in July 2020. Interestingly, revolving debt, which includes credit card debt, fell by about $ 300 million. But non-revolving debt, which includes personal loans, rose $ 12.6 billion.
Bottom Line: If you are in debt or are faced with an expensive but necessary purchase, your choice is how to attack the debt. Your goal is to minimize the risk of your debt getting worse. Make the right choice and before you know it you will be back on the road to tax sanity.
So let’s look at how you can decide whether you need a credit card or a personal loan for your debt situation. Read on and you will learn:
When to use a credit card
A few years ago I had a huge hole in the ceiling of my kitchen. It was the unfortunate result of a leaky roof and a monsoon-like storm that lasted for five days.
The bill for this fiasco? A cool $ 16,000. I was fortunate to have an emergency fund and credit card with a ridiculously low annual percentage (the perks of a long, currently drama-free credit history). It would be some time before my insurer approved the cover and I had to fix the roof before it rained again.
So I used an insurance-approved contractor and posted the cost of the premiums on my credit card at the low APR. I like having a low APR card just in case something goes wrong and I have to clear the bill for a month or two.
When the credit card bill was due, I paid it entirely from my emergency fund. Insurance paid for some of the repairs, and when I got that check, I refunded my emergency fund.
Using a credit card worked because I was getting rewards, I had the money in an emergency fund to pay the bill, and it was going to be a short-term financial problem.
But let’s change the scenario a little. Let’s say you have your own version of my kitchen ceiling, but you don’t have an emergency fund and you need a year to settle the bill. If you have good credit and cash flow, you can purchase a credit card with an APR of 0% to help fund your expenses.
You’ll need to make monthly payments on the bill and settle them before the introductory price ends. At the moment, 0% adoption rates typically last around 12 to 18 months. Note that the introductory period for purchases may be shorter than the introductory period for credit transfers. In this case, you may want to use an existing card and later transfer the amount to a credit transfer credit card with an introductory rate of 0%. However, be careful with the transfer fees, which range from 3% to 5%.
Advantages and disadvantages of credit cards
We start with the pros:
- Those with very good or exceptional credit scores can qualify for 0% introductory purchase APRs if they have to make an expensive purchase and can pay it off in a year or so.
- Consumers with good results and credit card debt have the option to use an introductory APR of 0% on a prepaid credit card and pay the balance without paying interest.
- Many introductory purchase APR credit cards have rewards so you can use the card to make payments and earn rewards while paying off your debt without interest.
- With a credit card, you get a revolving loan amount. You can get limit increases if you use the card responsibly.
Now the negative side of credit cards:
- If you get a new 0% APR card or balance transfer card to pay for an expense, you could go into debt adding to your balance. I therefore warn against using the credit card for new purchases. Pay off the debt first!
- Some of the best credit cards have annual fees.
- When using a credit card for a long term loan, you could run into serious debt due to compound interest on your balance.
I want to dig a little deeper into the ramifications of using a credit card for long term loan. Average APR for all types of credit cards in the US news database is between 15.58% and 22.83% so using a credit card for a long term loan can get expensive. You can likely get a much lower interest rate on a personal loan, especially if you have good credit.
When should a personal loan be used?
Suppose you need to replace your heating and air conditioning, which happened to me a few years ago too. Yes, my house is advanced middle aged and it’s falling apart.
Your credit cards have an APR of over 20% and your rainy day credit is a little worn out. You’re looking at a $ 4,000 investment and putting that amount on a high-yielding credit card and taking a few years to pay it off would be kind of insane.
In this situation you will get a private loan makes more sense. You will most likely get a better interest rate (unless your credit is bad) and make fixed installments over a number of years. You have a set monthly payment that you can add to your budget.
Go online and do the research so you can get the best price. You want to try rate comparison websites, your own bank, and out-the-box options like peer-to-peer lending companies.
Advantages and disadvantages of personal loans
In summary, here are the benefits of a personal loan:
- Personal loans have lower interest rates (unless you have bad credit) than credit cards, which makes them a better choice when it takes a few years to pay off debt.
- You can usually get the money you need to spend an expense quickly.
- You get a fixed rate of interest and a fixed monthly payment for the life of the loan.
And now the dark side of personal loans:
- When you have bad credit, you get a high interest rate. But this also applies to credit cards.
- Different fees will apply, so read the terms carefully.
- Depending on what the loan is for, you may need to provide collateral to secure the loan (e.g. a car loan).
What If You Need To Consolidate Debt?
The answer to that is pretty simple when you have good credit and multiple card or personal loan debts. If you can settle the debt in about 18 months, an introductory APR of 0% on a bank transfer credit card works well.
The only question is whether your line of credit is high enough to cover all of the debt that you want to transfer. If so, you can pay off your debts at 0% interest during the introductory phase. This will save you a lot of money.
But what if you don’t have good credit or it takes three to five years to pay off your debt? Then it’s time to a Debt Consolidation Loans.
Finding the right debt consolidation loan takes time, but stick with it until you find the best possible interest rate for your situation. You won’t get 0% interest, but if you take out long-term borrowing, you pay less interest on a personal loan than you would on a credit card.