If you need to fund an emergency, where should you turn? In a perfect world, you would have the cash saved to fund an emergency. I hate to break it to you, but we live in a far from perfect world. From a financial wellness perspective, sometimes that means we need to borrow money if we’re in a jam. One of the most common questions we get at your money line: “is it better to have a loan or credit card?”. It depends, so let’s break this question down a bit more together.
Key differences between a credit card and a personal loan
Though they both represent a liability owed to a creditor, there are differences between a credit card and a personal loan.
- A variable payment Your monthly payment on your credit card will fluctuate depending on your outstanding balance.
- Unknown payoff date As long as you make the minimum payment on a credit card, there is nothing that says you ever have to pay it off. Unless you’ve created (and are following) a repayment plan, you don’t have a set end date.
- You can keep returning to the creditor Until you reach your credit limit, you can keep increasing your outstanding debt.
- Fixed monthly payment A personal loan is an installment loan (more on this later) which means your monthly payment is fixed.
- The date of your last payment is established With a fixed monthly payment, you will know precisely when this loan will be repaid.
- This liability will be ever decreasing Unlike with a credit card, you can’t increase your outstanding balance on a personal loan, which means each payment you make ensures you’re closer to being free.
When should you use a personal loan?
There are advantages to using a personal loan, depending on your circumstances. There are situations in which using a personal loan makes sense. One of my favorite examples in which I’m an advocate for using a personal loan is as follows:
- John is a single dad with two children. John recently went through a custody battle, and the court and attorney fees coupled with the increased child-related expenses really took him by surprise. Over the last year, John maxed out two of his credit cards. However, a few months ago, John gained full custody of his children and is now working diligently to pay down his credit card debt and has been sticking to his budget.
In a situation like this, I would absolutely advocate for John to use a personal loan over his credit cards. John could look for a loan with a lower interest rate. This will likely not only save John money, but it could also improve his credit score (or save it from being pulled down from the high utilization.
Personal loan advantages
- It could be better for your behavior A personal loan having a fixed payment and initial loan amount ensures you get on a plan to eliminate the liability—a huge plus from a money psychology perspective.
- Lower interest rates This isn’t always true, but in most cases, a personal loan will have a lower interest rate than your credit card(s).
Personal loan disadvantages
- High limits If you have good credit, you might be able to secure tens of thousands in personal loans, which can be a recipe for disaster.
- Though “better” than credit card debt, it’s still debt We want to avoid unsecured debt (debt that isn’t backed by an asset like your home or auto) as much as possible.
When should you use a credit card?
After reading a bit more about personal loans, you might be wondering, “are personal loans better than credit cards?” In the scenario above, yes. However, there are plenty of situations where a credit card makes more sense for borrowers. For example: Sam just graduated from college this spring. She has a job lined up, but unfortunately, her new company didn’t offer any relocation assistance as part of the offer. Her income will be more than she needs, and she already has an excellent spending plan ready. To not take out any more student loans than she required, Sam has almost a zero balance in savings and won’t see her first paycheck for a couple of weeks. In this situation, Sam could use a line of credit to bridge the gap as long as she monitors her spending and makes debt repayment a priority as she builds her savings at her new job. Sam isn’t in an ideal situation, but if she can maintain responsibility, she will be just fine!
Credit card advantages
- No additional application(s) If you already have an outstanding credit card, you don’t need to jump through any extra hoops to access the funds for an emergency.
- Flexibility If you need to use credit to bridge a financial gap, you might not have the bandwidth to begin making larger payments right away.
Credit card disadvantages
Unfortunately, the advantages of credit cards are also the disadvantages of credit cards. The lack of barriers with respect to accessing the funds is one of the primary reasons consumers find themselves with higher balances than they desire. When you add access to the lack of large(r) minimum payments, you can find yourself with high unsecured debt balances before you realize it.
How credit card vs personal loan affect your credit score
Disclaimer: The exact algorithm for credit score calculation is not public information. As a result, we can’t know exactly how one credit product will affect your score over another. However, the general categories used are public information which is where we are drawing the following guidance. Now, should you get a credit card or a personal loan? Credit cards and personal loans will both impact your credit score, but they can impact your score in different ways. Let’s take a $5k personal loan and a $5k line of credit and look at how they can affect your credit score. If you need $5,000 to cover a house emergency and you have a $5,000 line of credit, using this line of credit will negatively impact your credit score. About ⅓ of your credit score calculation is based on what’s called “credit utilization.” It sounds more complicated than it needs to be. All this means is of the line of credit you’ve been extended; how much are you using? Your credit score will begin to decrease once you’ve used ~⅓ of your credit limit. In this case, if your limit is $5,000 and you need to extend your line fully, you will see a decrease in your score. The concern is that we cannot predict how much your score will drop and how long it will take to come back. From a credit score perspective alone, the line of credit is inferior to the personal loan option. Alternatively, if you had a $20k limit and you carried a $5k balance, you would not see a decrease in your score. Before you decide on a credit card or a line of credit, it’s essential to understand your timeline for repayment and your credit utilization. Knowing how long you’ll carry a balance will be integral in ensuring you don’t drag down your credit score too much.
Alternatives to personal loans or credit cards
- Savings I know this might seem obvious or flippant, but this is why saving for emergencies is so important. Should I get a credit card or a personal loan? The perfect answer is “neither.”
- Advanced paychecks If you need money in a pinch, you might be tempted to stop at a business offering cash advances. Please do not use this option. The interest rates are usually very high (much higher than with a credit card) and take money away from the future you, creating a long-term problem.
- Mortgage-backed products In 2021, many borrowers were able to leverage the equity in their homes when they needed funds. With interest rates on the rise, this option is no longer as viable. In addition, we generally want to avoid replacing an unsecured debt (credit card or personal loan) with a secured line (car or home loan). Putting the additional financial pressure on your primary residence is something we want to avoid if we can.
Personal finance advice should not be given in a vacuum, as the variables of your life can impact whether the advice is best suited for you. However, the general guidance above is a prime example of the work we do here at Your Money Line. Our job is to help your people when “life happens,” and sometimes that means looking at where they can access some needed funds. Contact us to learn more about how we can help protect your greatest asset, your people.