It is good that this question is being asked. Too often, consumers will jump into one of these options without having compared them properly. Unfortunately, by not putting some forethought into this decision, consumers are finding themselves paying more for their purchases in the long run; and that is the best-case scenario. Many are ending up in financial trouble that could take years to recover from.
The answer to this question can be a tough one at times. There is also no standard answer. Each situation is different, the answer being best determined on a case-by-case basis. There are a number of factors to take into consideration when trying to decide what the best option would be.
The amount that a person is looking to borrow will be a factor in deciding which financing option is best for them. Credit cards are designed for smaller purchases that can be paid off each month. If you’re looking to make a purchase within the low hundreds range such as minor car repairs or the latest video game console, then a credit card may be the better option. These are buys that they can have repaid within a month or two.
Taking out a personal loan is the better option if someone needs a larger ticket item like a new refrigerator or a higher dollar amount in general. Loan providers prefer the funds they lend out to go towards a specific purpose rather than just to pay for gas and groceries. Bigger car repairs, debt consolidation, buying a new motorcycle, or even extra cash for bills during the Christmas season are all purposes that generally fit the criteria.
With a loan, a person has longer to repay the borrowed funds since the dollar amounts are higher than what would be charged on a credit card. Instead of rushing to pay the loan off in two or three months, the borrower will typically have two to three years to do so, often times even longer. This can be a good thing because it reduces the financial strain repayment of thousands of dollars can put on an individual.
It comes at a cost, however. The interest rate on the loan will accrue over the course of the loan’s lifespan. This can be anywhere from 5% to 36% of the amount borrowed. This is why a consumer should shop around for the best annual percentage rate (APR), not just among loan lenders, but among credit cards as well. If a borrower requires an amount of money that either a loan or a credit card could cover, they need to find the interest rate that will save them the most money.
Credit card APRs typically range between 14% and 29%, with the average currently sitting at 16.71%. These rates are determined by a person’s credit score and other specific criteria the lending institution has established. Prior to making a decision on which financial option will work best, consumers should look at their budget to determine how much they can afford each month to repay the borrowed amount. Then they should do the math, using a variety of interest rates, to see what the monthly payments would come to.
A person will not know the interest rate a lender will offer at this point – they are just now starting to shop around for the best option – so they will have to estimate the rate based on their credit score. The higher a credit score is, the lower the APR will usually be (more on credit scores below). By taking the time to work through the different outcomes, the borrower will be able to visualize how much they will be spending a month as well as how much they will be repaying with interest rates factored in.
A person’s credit score will be the deciding factor, above all others, for the interest rate they receive. There is additional criteria that each loan provider and credit card issuer has that can raise the rate or reduce it, but this is minimal in comparison to the effect a FICO score has on the APR. This is why it is crucial to maintain a healthy credit history, and to start repairing that history as soon as possible if it is suffering. As previously mentioned, a consumer will receive a lower APR if they can show that they are responsible spenders and can manage their debts properly.
The average credit score in the United States is a 687. This will earn a person a medium-ranged APR. Anything higher than a 740 will qualify a borrower for the lowest interest rates a lender can offer. If a score is below a 670, lenders will begin offsetting the risk of default by charging higher interest rates. Both personal loan providers and credit card issuers follow this industry standard so, if someone wants to make a purchase they cannot afford on their own, they need to have a fairly clean credit history to do so.
There is additional criteria that comes with either borrowing option. For credit cards, a cardholder may be required to put a deposit on the card. These are called secured credit cards, and they are used for people establishing or reestablishing their credit. For borrowers with low credit scores who find a credit card would be the best option for their purchase, this may be the type of card issuers offer. Secured cards protect the institution from defaults while giving the cardholder the ability to make the desired purchase.
Many types of personal loans require protection from defaulting as well. This comes in the form of collateral. By putting up some form of personal property, borrowers can receive the requested amount of money while giving the lender something of value to help them recover any losses that may occur if the borrower is no longer able to repay the loan. Collateral can be any type of mechanical or electrical equipment, a vehicle title, stocks or bonds, jewelry, or any number of properties with a resale value.