What’s the difference between a personal loan and a line of credit?

Both personal loans and credit cards are types of unsecured loans — requiring no collateral — that can be used for almost any type of personal purchase. There are, however, a few key differences.

A personal loan is disbursed in one lump sum, typically between $1,000 and $100,000. It is then paid back in equal installments over a predetermined period of one to seven years.

A credit card, on the other hand, is a form of revolving debt. When you open a card, you’re given a credit limit. This limit is a fund you can borrow from as many times as you want. Whenever you pay your bills, it frees up the funds so you can borrow more. Unlike the fixed timeline of a personal loan, you’re able to borrow with a credit card (and stay in debt) indefinitely.

Understanding the appropriate times to use each of these forms of debt can help you organize your finances and pay as little interest on your debts as possible.

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When to use a personal loan

A personal loan makes financial sense when:

You’re eligible for a low APR

Interest rates for personal loans vary widely — from 3% to 36% — and proceeding with this kind of loan makes financial sense only if you qualify for a low rate. The rate you’re eligible for is determined by your credit history, debt-to-income ratio, employment status and other factors that measure your creditworthiness.

The less risk you present as a borrower, the better the rates you’ll find.

To quickly estimate the rates you qualify for, you can pre-qualify for loans online with various lenders.

You need to finance a significant, one-time expense

Many personal loans have a one-year minimum term, so they make sense for large purchases that will take longer than one year to pay off. If you use a personal loan for something you can repay in less than a year, you’ll pay unnecessary interest.

Personal loans can be a good option for unexpected expenses and home improvement projects that will increase the value of your home.

You’d like to consolidate large, high-interest debts

If you have multiple high-interest loans, you can save money by taking out a personal loan to pay them all off. In doing so, you’ll not only pay less interest, but you’ll also have one convenient monthly payment that’s easier to manage.

You’re capable of making monthly payments over the loan term

Take a look at your current finances. If you add another debt to the list, will you have enough at the end of the month to comfortably make the payments?

The last thing you want to do is default on your loan. As with credit cards, missed payments on personal loans will tank your credit score.

Pros and cons of personal loans

Pros

  • Flexible with few limitations on what they can be used for.
  • Lower average APR than credit cards for borrowers with excellent credit.
  • No collateral is needed to secure a personal loan (unlike with home and auto loans).
  • Consolidation of multiple debts into one fixed monthly payment makes it easier to budget and manage finances.
  • You can access large sums quickly with convenient online application processes.

Cons

  • Interest rates can be higher than credit cards for those with fair or bad credit scores.
  • Some lenders charge loan origination fees and penalties for paying off a loan early.
  • Most lenders don’t allow terms of less than one year.
  • Higher monthly payments (compared to a credit card minimum payment) mean lower monthly cash flow.
  • Consolidating credit card debt with a personal loan opens up the opportunity to abuse credit cards and fall further into debt.

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When to use a credit card

Credit cards are the way to go when:

You want to finance smaller expenses

Each time you swipe your card, you’re essentially approved for a mini-loan. You can take out as many of these mini-loans as you want until you reach your credit limit. Then, when you pay off those mini-loans, you can continue borrowing more. This revolving debt system makes it convenient for smaller purchases and everyday spending.

You qualify for a 0% promotional offer

Some credit cards offer introductory interest rates of 0% that can last from six to 20 months. You can essentially borrow money for free during this period. If you use these cards to consolidate small debts, or make larger purchases that can be paid off during the introductory rate period, you’ll save money on interest.

You can pay off your balance in full each month

In May 2021, the average credit card APR was 16.15%. This can shoot even higher if you have poor credit. Unless you are taking advantage of a 0% APR offer, you should use a credit card only for expenses you can repay in full each month. Carrying a balance from month to month is an extremely expensive way to borrow money.

If you do pay off your balance in full each month, no interest is charged, and you get a free short-term loan.

You want to earn rewards

Many credit cards offer rewards programs that allow you to earn cash back, airline miles or other rewards for the purchases you make with your card.

Often, if you meet a spending requirement within the first few months of opening these cards, you can earn sign-up bonuses worth hundreds of dollars or more.

For example, if you open the Chase Sapphire Preferred card and spend $4,000 in the first three months, you’ll earn rewards valued at more than $1,000.

In other words, if you pay off your balance each month, you are essentially being paid to borrow money.

Pros and cons of credit cards

Pros

  • Low minimum monthly payments of 2% to 4% of your balance allow you to free up cash flow if you’re struggling to make ends meet.
  • The revolving nature of credit cards means you don’t have to constantly apply for new loans.
  • You can pay off your balance early without penalty.
  • They allow you to borrow money interest free until your monthly bill is due.
  • Rewards cards pay you to borrow money (if you always pay your balance in full).
  • Introductory offers of 0% can be used to consolidate existing debt and avoid paying interest.

Cons

  • Lower borrowing limits than personal loans.
  • Managing debts across multiple cards is more complicated than having one consolidated personal loan with fixed payments.
  • The ongoing nature of revolving credit makes it easier to prolong your debts indefinitely.
  • Higher APRs make carrying a balance expensive.
  • Some credit cards have annual fees.
  • Credit cards are not accepted everywhere, and some merchants charge extra processing fees.

When is a credit card better than a personal loan?

Credit cards are better than personal loans for small, everyday purchases that you plan to pay off before the end of the month.

Zero percent APR credit cards are also preferable to personal loans for consolidating small debts. Unlike a personal loan, if you can pay off the card during the 0% introductory period, you won’t pay any interest.

Lastly, a credit card makes more sense if you have fair or poor credit, do not qualify for a low-rate personal loan, or you want to use it as a tool to build your credit history.

When is a personal loan better than a credit card?

Personal loans are better than credit cards when you need to finance a larger, one-time purchase that exceeds your credit card limits. They are also ideal for purchases that will take longer to pay off than the introductory periods of any 0% APR credit cards you might qualify for.

If you have multiple, high-interest debts that exceed the limits of a 0% APR credit card, a personal loan is your next best option for consolidation. It not only can reduce your interest rates, it simplifies your finances with one fixed monthly payment.

Lastly, credit cards have low monthly payments that essentially give you the option to extend your debt forever. If you want accountability and pressure to pay off your debts by a certain date, the fixed nature of a personal loan can help.

Summary

As you can see, there’s a time and a place for both credit cards and personal loans.

If used strategically, each one can help you save money and pay off your debts faster.

To get started, shop around for the best rates on personal loans or check out today’s best credit card offers.

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About the Author

Mitchell Glass

Mitchell Glass

Freelance Contributor

Mitchell is a freelance contributor to MoneyWise.com.

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