If you find yourself in a situation where you need a little financial help, take time to think about your options. Automatically reaching for a credit card – or applying for a personal loan – might not be the best money move.
According to the Federal Reserve, consumer debt increased $12.3 billion month over month in July 2020. Interestingly, revolving debt, which includes credit card debt, decreased about $300 million. But nonrevolving debt, which includes personal loans, grew by $12.6 billion.
Bottom line: If you have debt or are facing an expensive but necessary purchase, you can choose how you want to attack the debt. Your goal is to minimize the risk of making your debt worse than it already is. Make the right choice, and before you know it, you’ll be on your way to fiscal sanity again.
So let’s take a look at how to decide whether you need a credit card or a personal loan for your debt situation. Keep reading, and here’s what you’ll learn:
When to Use a Credit Card
Several years ago, I had a giant hole in my kitchen ceiling. It was the unfortunate result of a leaking roof and a monsoonlike storm that lasted for five days.
The bill for this fiasco? A cool $16,000. I was fortunate to have an emergency fund and a credit card with a ridiculously low annual percentage rate (the perks of having a long, currently drama-free credit history). It was going to take my insurer some time to approve the coverage, and I needed to fix the roof before it rained again.
So I used an insurance-approved contractor, and I put the expense on my low-APR credit card for the rewards. I like having a low-APR card just in case something goes wrong and I need to float the bill for a month or two.
When the credit card bill was due, I paid it in full from my emergency fund. Insurance paid for part of the repairs, so when I got that check, I reimbursed my emergency fund.
Using a credit card worked because I earned rewards, I had the money in an emergency fund to cover the bill and it was going to be a short-term financial problem.
But let’s change the scenario a bit. 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 pay off the bill. If you have good credit and enough cash flow, then you could get a credit card with a 0% introductory purchase APR to fund your expense.
You’ll have to make monthly payments on the bill and pay it off before the intro rate ends. Right now, 0% intro rates usually last about 12 to 18 months. Note that the intro period for purchases may be shorter than the intro period for balance transfers. In that case, you may want to use a card you already have and transfer the amount later to a balance transfer credit card with a 0% intro rate. But be wary of balance transfer fees, which range from 3% to 5%.
Pros and Cons of Credit Cards
We’ll start with the pros:
- Those with very good or exceptional credit can qualify for 0% introductory purchase APRs if they need to make an expensive purchase and can pay it off in a year or so.
- Consumers with great scores and who have credit card debt have the option to use a 0% introductory APR on a balance transfer credit card and pay down the balance without paying interest.
- Many 0% intro purchase APR credit cards have rewards, so you can use the card for payment and earn rewards while you pay off debt interest-free.
- You get a revolving amount of credit with a credit card. You can get limit increases when you use the card responsibly.
Now, the negative side of credit cards:
- If you get a new 0% purchase APR card or balance transfer card to pay an expense, you can end up in debt if you add to your balance. So, I caution against using the credit card for new purchases. Pay off the debt first!
- Some of the best credit cards have annual fees.
- If you use a credit card for a long-term loan, you could end up in serious debt due to compound interest on your balance.
I want to dig a bit deeper into the consequences of using a credit card for a long-term loan. The average APR for all types of credit cards in the U.S. News database ranges from 15.58% to 22.83%, so using a credit card for a long-term loan can get expensive. You can probably get a much lower interest rate with a personal loan, especially if you have good credit.
When to Use a Personal Loan
Suppose you need to replace your heating and air conditioning unit, which also happened to me a few years ago. Yes, my house is in advanced middle age, and it’s falling apart.
Your credit cards have APRs north of 20%, and your rainy-day fund is a little worse for wear. You’re looking at a $4,000 investment, and putting this amount on a high-interest credit card and taking a few years to pay it off would be kind of insane.
In this situation, getting a personal loan makes more sense. You’ll most likely get a better interest rate (unless your credit is bad), and you’ll be making fixed installment payments over a few years. You’ll have a set monthly payment to include in your budget.
Hop online and do some research so you get the best rate. You want to check out rate comparison websites, your own bank and outside-the-box options, such as peer-to-peer lending companies.
Pros and Cons of Personal Loans
To summarize, here are the pros of a personal loan:
- Personal loans have lower interest rates (unless you have poor credit) than credit cards, making it a better choice if you need a few years to pay off the debt.
- You can usually get the money you need for an expense quickly.
- You’ll get a fixed rate and a set monthly payment for the life of the loan.
And now, the dark side of personal loans:
- If you have bad credit, you’ll get a high rate. But this is also true for credit cards.
- There will be a variety of fees, so read the terms carefully.
- Depending on what the loan is for, you might have to put up collateral to secure the loan (e.g., a car loan).
What if You Need to Consolidate Debt?
The answer to this is pretty simple if you have great credit and have debt on several cards or personal loans. If you can pay off the debt in 18 months or so, then a 0% introductory APR on a balance transfer credit card is a good fit.
The only question is whether your credit limit will be high enough to cover all the debt you want to transfer. If it is, then you can pay off your debt at 0% interest during the intro period. You’ll save a lot of money this way.
But what if you don’t have good credit or you need three to five years to pay off your debt? Then, it’s time to look at a debt consolidation loan.
Seeking the right debt consolidation loan takes time, but keep at it until you can find the best possible rate for your situation. You won’t get a 0% interest rate, but for long-term borrowing, you’ll pay less interest with a personal loan than you will with a credit card.
