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Personal Loan vs Credit Card: How to Know Which is Better for You

Personal-Loan-vs-Credit-Card

Personal Loans Vs. Credit Cards - Which Do I Choose?

When the time comes that you decide to get a loan, there are many available options. You want to make sure that you select the right type, but where do you start? According to the Chamber of Commerce, over 176 million Americans have credit cards while only 19.1 million have an unsecured personal loan. Although credit cards take the lead in current quantity, according to Experian, personal loans are the fastest-growing debt category in the U.S.

From the basics to the more complex, by the end of this article, you should understand the key differences in two common loan types – credit cards and personal loans – and which one will best meet your needs.

What is a Personal Loan?


Personal loans are closed-end loans that can be obtained for almost any purpose, from home improvement to medical bills. A closed-end loan has an established end date at which the loan will be paid off and closed after the completion of periodic payments throughout the term of the loan. Personal loans can be secured or unsecured. 

Secured vs. Unsecured Loans

Typically, secured loans are considered less risky, so you are more likely to qualify for this type if your credit is not as high as you would like. If a personal loan is secured, the loan requires collateral.

If it is unsecured, the loan does not require collateral. Collateral is where something of value is pledged as security for the loan. If you do not repay the loan as promised, you will lose the collateral item to repay the debt. Common examples of this are cars being used as collateral for automobile loans and houses as collateral for mortgages.

Items that can be used as collateral for secured personal loans are cars, homes, savings accounts, certificates of deposit, and other investment accounts. Some lenders even accept non-conventional items such as jewelry or other valuables.

Pros and Cons of Personal Loans

Pros
• If you have good credit, personal loan rates will be lower than that of other unsecured loan types such as credit cards.
• Unsecured personal loans are not required to have collateral.
• Personal loans can help build your credit score.
• You can get funds needed for a larger purchase while only making smaller monthly payments.
• You can improve your credit score and save money by consolidating multiple debts, such as credit cards, into one personal loan.


Cons
• A personal loan might take time to build up credit in the payment history category.
• You are committed to making the monthly payment until the loan has been paid.
• If your credit is not good, rates can sometimes be as high or higher than credit card rates.

Visit our website to see the personal loan programs offered at 121FCU. With unsecured and secured products and loan amounts from $500 to $50,000.00, we have options to meet your needs. Our members enjoy fixed interest rates and low minimum payments on these loans.

What Is a Credit Card Loan?


Credit cards are attached to an open-end line of credit. This means that the loan remains open for as long as you and the lender choose, provided you follow account requirements such as making payments when required. This is also commonly called revolving debt. You can continue to borrow and repay money for as long as the account is in good standing and there is an available balance. When there is a balance on the loan, you make monthly payments until the balance is paid off.

Pros and Cons of Credit Cards

Pros
• Your credit card is tied to a revolving loan that remains open for as long as you need. You can pay any balance off and continue to use it indefinitely. Even if you don’t plan to use it right away you can keep it on hand just in case the need arises or an emergency occurs.
• You can select a credit card that earns rewards such as gift cards, merchandise, airline miles or cash back.
• You can get the benefits of a credit card without paying interest if you pay your balance off before the grace period ends.
• Credit cards can help build your credit score.
• Collateral is not required, so personal possessions are not at risk of loss.
• There are secured card options available to help people with no credit or bad credit help build up their credit score.
• There are credit card offers are available that offer an introductory rate of 0%. This is ideal if you have short-term debt.
• Some major card brands offer lesser-known benefits such as car rental insurance.
 
Cons
• If you don’t pay off your balance you will be charged interest.
• Credit cards typically have a higher interest rate than other loan types.
• It is easy to build up balances on the card.
• Late fees occur quickly if payments are not made on time.
• High balances can lead to quick drops in credit.

Visit our website to see the excellent credit card programs offered by 121FCU! With the following options to choose from, we are sure to have one that meets your needs!
• VISA Signature
• VISA Platinum Rewards
• VISA Platinum Secure

What Should I Expect in the Application and Approval Process


Before you apply for either a credit card or a personal loan, it is helpful to know what lenders look for to prepare. You might wonder what is involved in the approval process.

What Lenders Look For

Lenders look at these following factors when deciding whether to issue credit:

Credit Score and Report:

121Glossary-FICOLenders will review to see where your credit score stands. This not only affects whether you will be approved for the loan but also what APR you qualify for. Most lenders use your FICO score to see if there are any red flags.

Base FICO® scores range from 300 to 850 and are made up of the following factors with percentage of weight of importance:

  • Payment history: 35%
  • Amounts owed: 30%
  • Length of credit history: 15%
  • New credit: 10%
  • Credit mix: 10%

 

121Glossary-ATRAbility to Repay:

Regulations require that lenders make sure you can repay your loan.

Lenders might request proof of employment. They will look at how long you have been employed to ensure you have a steady stream of income. It is common for a lender to request a copy of a paystub.

For larger loan amounts the lender might even call your employer to verify your employment and income.  Additionally, some may factor in and calculate the value of any assets you may have. 

 

Debt-to-Income Ratio:

121Glossary-DTILenders will check your ability to repay your loan with a debt-to-income ratio, commonly phrased as DTI. Debt-to-Income Ratio = Sum of Monthly Debt Payments / Gross Monthly Income

This handy tool from CUNA helps you calculate your debt-to-income ratio and determine where your financial health stands. CUNA lists that a debt-to-income ratio of under 36% is ideal. Getting a personal loan for debt consolidation might be beneficial for borrowers with high DTI.
 
Note that only items for which you are in debt for count in the debt section of your debt-to-income ratio. You do not include utility bills or other similar bills.

Are There Differences in the Approval Process for Personal Loans Vs. Credit Cards?


Both loan types typically have similar approval processes, which in the current electronic age is typically simple. The applicant will provide their personal information and identification documents, along with any required proof of income or assets to the lender. The lender will review these, along with the applicant’s credit report and score, and make an approval decision. There are differences in the approval process for secured loans.

Secured credit cards are typically only secured by money, such as funds in a savings account. Some lenders will get more creative with what they allow for collateral on a secured personal loan. To get through the approval process for these, you will have to meet individual lender requirements. For example, if you use your car as collateral, a lien may be placed on your car and you might have to provide proof of insurance, just like a traditional automobile loan.

Personal Loan Vs Credit Card – Which One Is Better for Your Credit?


When used correctly, both personal loans and credit cards can help build your credit. To fully understand how your credit affects these loans, and how these loans affect your credit, let’s first look at the categories that make up your credit.

Credit Report Categories


According to CreditCard.com, five main components make up your credit. These categories each affect your credit score at different levels. The list below is in order from the highest impact to lowest impact.

1. Payment History -
 
Payment history is the strongest factor affecting your credit. It takes time to build up your payment history by making payments as agreed, but your score is quick to drop if you miss a payment. If you have made your payments as agreed on previous loans, it shows that you are more likely to continue making your payments as agreed. If you haven’t paid as agreed in the past, it is going to be much more difficult to get new credit, or it will result in higher rates. The more recent a missed or late payment is, the more significant of an impact it has on your credit score. The impact lessens over time until it eventually falls from your report.

2. Credit Utilization
 
Making up almost a third of your score, credit usage can very quickly affect your credit score. It is important in maintaining good credit to keep a low credit utilization rate.

Credit Utilization Rate = Amount of revolving credit you are currently using/Amount of revolving credit you have available.

For example, let’s say you have two separate credit cards. One of them has a $5,000.00 credit limit. The other has a $3,000.00 limit. If you have a $2,500.00 balance on the card with a $3,000.00 limit, this amounts to an 83% utilization rate on that card and a 31% utilization rate across all accounts.

Having a high utilization rate on a single account can affect your score, but credit utilization across all accounts has a higher impact.

3. Length of Credit History
 
The older your credit history, the more beneficial to you – if it is a positive history. This is what can cause challenges for people who have not yet built up credit, even if they don’t have any negative items on their report.
 
The following things factor into this category:
• The age of your oldest account.
• The age of your newest account.
• The average age of your accounts.
• Whether accounts are active or inactive.

4. Credit Mix
 
This refers to the type of loans you have open. If you have three separate credit cards open, but no other loan types, this isn’t going to reflect as well as if you have a credit card, an auto loan, and a mortgage. It is standard advice to have three separate credit types to help build credit.

5. New Credit
 
Every time that you apply for a loan, a hard credit inquiry hits your credit report. These inquiries might lower your score by a few points but don’t typically have a strong impact. However, if you have had many hard inquiries over a short period of time, this could raise red flags for lenders.

When shopping for credit, many people mistakenly believe that each credit inquiry affects their credit score and they are then afraid to get multiple quotes. This is incorrect. The credit bureaus recognize that you are loan shopping and groups all inquiries within a certain date range together. This article from MyFICO explains this process in more detail and suggests doing your rate shopping within 30 days.

How Do Personal Loans Impact Your Credit?


The components that make up credit have now been established. Personal loans directly touch all of the categories in your credit report except credit utilization. Personal loans will improve your credit over time by making your payments as agreed and providing an additional source for your credit mix. However, these loans can make the biggest impact on your score indirectly.
 
If you have many revolving accounts on which balances are getting high, you can finance these into one personal loan. Doing this could drastically improve your credit utilization and provide a very positive impact on your credit.

How Do Credit Cards Impact Your Credit?


As the name may indicate, credit cards play a large role in determining your credit. Used correctly, they can raise your credit. Use incorrectly and your credit could plummet. While credit cards impact all of the categories in your credit report, they play a major role in credit utilization.
 
Since credit cards play a major role in credit utilization, and credit utilization makes up almost a third of your credit, credit cards significantly impact your credit. If you use your cards responsibly by keeping low balances, this can greatly increase your credit. However, if you rack your balances up you can see a swift drop in score.

So, Which Is Better for Your Credit?


To summarize, both loans can affect your credit both positively and negatively, depending on how they are used. If your goal is to build up your credit as quickly as possible, a credit card would be the better option, as it touches two high impact areas of your credit score. However, this is only true if you keep your credit utilization low.

If you need to borrow a large sum of funds, a personal loan would be better for your credit. It would also be beneficial for your credit to refinance several large-balance revolving loans into one personal loan.

To check how various actions such as opening a new loan, closing loans, and other activities might affect your credit, Credit Karma offers a free credit score simulator.

When Should I Get a Personal Loan?


To summarize, it is best to get a personal loan in the following circumstances:
• Long-term debt.
• Larger purchases.
• Debt consolidation.

When Should I Get a Credit Card?


It is best to get a credit card in these circumstances:
• Short-term debt.
• To utilize rewards programs Keep in mind that if you don’t pay off the balance before the grace period ends, credit card interest could outweigh the benefits.
• To keep on hand in case of emergency.
• To quickly build up credit.
 
when-should-i-get-a-personal-loan-vs-credit-card

Hopefully, the difference between a personal loan vs credit card is now clear, along with which is better for your credit in each situation. Don’t forget to visit 121FCU and check out our great personal loan and credit card options or contact us for FREE FINANCIAL COUNSELING!
 

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