When faced with the choice of making a major purchase using a credit card or a personal loan, your first choice should be neither.
Your first choice – if you can’t pay back the purchase by the end of the month – should be cash. If you don’t have the money, consider skipping the purchase until you’ve saved enough money.
Well, that might be easier said than done.
There may be important life milestones, medical needs, and other purchases that require financing, depending on your personal financial circumstances and financial goals in life.
While credit cards have many benefits and offer all kinds of rewards (cashback, travel, and more), they’re not always the best option — especially for longer-term funding needs.
For those big purchases and life milestones — when you don’t have enough cash on hand — a personal loan can be a more cost-effective option.
What is a personal loan?
A personal loan is an unsecured loan, usually between $1,000 and $100,000, with fixed or variable interest rates that can be used for large purchases or debt consolidation. The term “unsecured” means that there is no underlying collateral attached to the loan. For example, if you mortgage your home, your mortgage is a “secured” loan, with your home as collateral. If you default on your mortgage, your lender will own your home.
Because a personal loan is unsecured, there are no underlying securities associated with a personal loan. As a result, the interest rate on an unsecured loan like a personal loan is higher than the interest rate on a secured loan like a mortgage because the lender is taking on more risk.
However, personal loan interest rates are often much lower than credit card interest rates, which are typically between 10% and 20% (or higher). Depending on your credit profile, you may be able to qualify for a low interest rate personal loan and save money compared to a credit card. The interest rate on your personal loan depends on several factors, which may include your credit rating, credit history, and debt-to-income ratio.
When should you use a personal loan?
Personal loans are best for purchases that you plan to pay back in less than five years. Unlike student loans or mortgages, which are issued for specific purchases such as education or a home, personal loans can be spent at one’s discretion.
1. Debt Consolidation
Debt consolidation is one of the most popular reasons for taking out a personal loan.
When you consolidate your debt, you combine all of your existing debt into one loan, allowing you to make one monthly payment instead of multiple monthly payments. If you can get a lower interest rate by consolidating your debt compared to your current credit card rate, a personal loan can help you pay off your debt faster.
For example, if you already have credit card debt, you may be able to get a personal loan at a lower interest rate than your existing credit card rate. For example, if you have $10,000 in credit card debt at 15% interest and can get a personal loan at 7% interest (depending on your credit profile and other factors), you could potentially reduce your interest payments by more than 50%.
When consolidating your debt, you should think about how and why you acquired that debt. Understanding the how and why is even more important than lowering the interest rate with a personal loan. Was it a bad spending habit? Is a monthly budget missing? Liquidity constraint? Do you need more income? Creating a monthly budget to monitor your income and expenses will help you better manage your monthly cash flow.
Comparison of personal loans and credit cards
First, you need to compare the interest rate on your credit card to the interest rate on the personal loan to determine which interest rate is lower. Responsible borrowers should be able to achieve a lower interest rate with a personal loan. Second, you need to understand that if you qualify for a lower interest rate, how many years it will take you to pay off your personal loan versus your credit card debt, and whether you are happy with the repayment period. A shorter loan repayment period can not only save you on interest costs, but also create discipline to pay off your debt faster.
2. Medical expenses
If you have a medical emergency or unexpected medical expenses and are unable to pay the full cost in cash upfront, a personal loan may be a better solution than a credit card. You can often qualify for a higher loan amount with a personal loan than with a credit card, which may be necessary for your healthcare expenses.
If you need to do an emergency repair or small home improvement project and can’t get a home equity loan, access a line of credit, or refinance a mortgage, a personal loan can be an attractive option. A personal loan may make financial sense for a home renovation project if the renovation will improve the financial value of your home (and the cost of borrowing the home loan is less than the expected increase in the value of your home as a result of the home renovation project).
Other uses for a personal loan
wedding. According to The Knot 2016 Real Weddings Study, the average cost of a wedding last year was $35,329. In Manhattan, the average cost is $78,464 — more than double the national average. If you are planning to get married and do not have the financial means to pay for your wedding, then it is best to consider a smaller wedding and find ways to reduce the cost without borrowing. If this is not feasible, a personal loan can save you interest costs compared to a credit card.
Other important life events. Personal loans can be obtained to fund other important life events including an engagement ring, a baby, moving house, honeymoon and many other purposes. However, your best personal loan choice is debt consolidation so you can lower your interest rate, pay off your debt faster, and be on your way to financial freedom.