Borrowing money comes in various forms. When you need some extra funds to cover your individual needs, personal loans and credit cards are the most commonly used options. While both of them provide extra financing for unexpected expenses and major purchases, they still work differently. Knowing their key features will help you decide on what option better meets your needs. Here's a detailed look.
How Does a Personal Loan Work?
A personal loan provides you with a lump sum deposit you need to repay in equal monthly installments (EMIs) within the agreed-upon period. Along with a principal amount, there's an interest rate per annum that is expressed in a certain percentage of the borrowed sum. Personal loan interest rates are usually fixed, meaning that they don't change over the loan life.
Each time you make your loan payment, you cover a portion of your principal amount while the remaining sum goes toward covering interest. Personal loan interest typically ranges from 9.99% to 24% p.a., but some options may come with APRs as high as 44%. The amount you can borrow is usually up to Rs. 50 lakhs, with some lenders offering higher sums. The repayment period usually spans from 12 to 84 months.
Advantages
- Flexible repayment options. You can choose a convenient loan duration and split the cost of an expensive purchase over several months or years. This flexibility allows you to adjust your loan payment to your financial situation;
- Predictability. As an interest rate doesn't fluctuate, you will always know how much you need to pay each month, making it easier to budget;
- Reasonable costs. Personal loans come with favorable interest rates. Borrowers with good credit scores can expect to pay as little as 9.99% p.a;
- High loan amounts. You can borrow as much as Rs. 50 lakhs or even more, provided that you're solvent enough.
- You don't need to save money on what you need right now. Persona loans allow you to buy something expensive even if you don't have enough money in savings;
- Credit-building opportunities. Each on-time loan payment boosts your credit score, as your payment history makes up about 35% of your credit rating.
Disadvantages
- May not meet your short-term needs. If you need a small sum to cover unexpected expenses, a personal loan might not be an option due to the high minimum loan amounts;
- Total loan cost may be high. Personal loans are long-term commitments that involve more overpayment over the loan life;
- Funding may take some time. Personal loans may not meet your urgent needs. It usually takes about 2 to 5 business days for lenders to transfer money to you;
- Strict requirements. Banks and NBFCs offering personal loans usually set severe income and credit score requirements an individual must meet to qualify. Bad credit borrowers or those with low income may find it difficult to get this traditional form of financing;
- May damage your credit score. If you pay late or miss your payment, a lender may report it to credit bureaus, which will affect your credit rating. Additionally, each personal loan application typically involves a hard credit check that reduces your credit score by a few points.
How Does a Credit Card Work?
A credit card is a type of revolving credit that is linked to a bank account with a certain credit limit. You can access the money within this limit each time you need extra financing. Then, you can either repay the sum you owe by the end of the billing cycle or make just a minimum payment, which is a percentage of the amount borrowed.
If you cover the full sum you used, there may be no interest applied, and you will be able to use the money again. When you make only a minimum payment, interest accrues to the remaining amount you owe. This way, you may accumulate debt over time. Some issuers also offer 0% APR credit cards that have a certain interest-free period. If you manage to repay what you used within this term, you won't be charged any extra interest.
Credit cards usually have variable interest rates that may change over time. An average credit card APR may be between 8.5% and 45%. Additionally, lenders may apply extra fees, such as annual charges or renewal fees. Your credit limit will be determined based on your income, credit score, and current debts. It usually ranges from a few lakhs to crores of rupees. Many issuers set limits that not exceed twice an individual's monthly income.
Note: Credit card purchases are not the same as credit card withdrawals. When you get a credit card cash advance, other interest rates will apply and accrue immediately.
Advantages
- Quick access to funds. Once you already have a credit card, you can access the money within your limit each time you need it most without undergoing any application procedures;
- Extra perks. Many credit cards come with various perks, such as cash back or travel rewards, allowing you to benefit from paying by the card;
- You can potentially save. If you manage to repay what you used within a billing cycle, you may not be charged any interest;
- You can build credit. Showing your responsible credit card utilization will positively affect your credit history;
- Wide use. Credit cards are usually accepted almost everywhere, so you can turn to any time you need extra financing.
Disadvantages
- Debt accumulation. If you only make minimum payments, interest will apply to the remaining sum you owe. This way, you may find yourself dealing with more debt than you can afford in the long run;
- Higher interest rates. Credit cards often have higher interest rates compared to personal loans. This involves a higher total loan cost;
- Less predictability. Credit card APR can change over the loan life, which will affect the cost of borrowing;
- May result in overspending. It's good to always have an emergency fund alternative to turn to, except for situations where you have bad spending habits. Easy access to funds may become a starting point to unnecessary debt and more interest paid over time.
Personal Loan vs. Credit Card: Comparison Table
The table above will help you compare these two options and make an informed borrowing decision:
| Factor | Personal Loan | Credit Card |
|---|---|---|
| Application Process | Usually requires a borrower to visit a lender's store in person with all the needed documents. It may be an option to pre-qualify on the lender's website without affecting an applicant's credit score | Many lenders allow borrowers to apply online, but there are issuers that require you to visit a store in person |
| Average APRs | From 9.99% to 24% p.a., typically fixed | Between 8.5% and 45%, usually variable |
| Loan Amounts | Up to Rs. 50 lakhs or even more | A credit limit can be from a few lakhs to crores of rupees. Some issuers limit it to twice an individual's monthly income |
| Repayment Tenures | From 1 to 7 years. A borrower makes equal monthly payments within the loan life | Revolving credit. A borrower may only make a minimum payment, which is calculated based on how much money they have used. Interest will accrue on your outstanding balance |
| Credit Score Requirements | Minimum requirements can range from 650 to 750, depending on the lender | Usually no less than 700 but there are credit cards for almost any credit |
| Credit-Building Opportunities | You can build or improve credit by making on-time payments as they are reported to credit bureaus. Late payments result in credit score drop | Can help you build credit if you make your payments on time and maintain low credit utilization. This means that you should use no more than 30% of your overall credit limit. Late payments or overuse can result in a credit score drop |
| Collateral | None | None |
| Funding Times | From several business days to several weeks, depending on the lender and time you apply | From a few days to a month, depending on the lender. Once you have a card, you can use the money whenever you need it |
Which Option Should You Choose?
Your choice depends on your current financial situation, loan purpose, and spending habits. Personal loans may suit you if you need a fixed amount to make a big purchase or finance a major life event. They are also handy if you want to split the item's cost over multiple fixed installments and reduce the financial burden.
Credit cards are handy if you need emergency money to quickly turn to when unexpected expenses pop up. They will work best for borrowers with good financial habits who prioritize repayment by the end of the billing cycle.
Alternative Options
If both options considered don't seem to be a perfect fit, here are a few alternatives you can turn to.
Loans against Property
If you own some property, you can get a loan backed by its value and access a lower interest rate. This way, the equity you own will serve as collateral, meaning that a lender can seize it if you fail to repay your loan. The amount you can get is determined as a percentage of the equity you own in your house or other type of property. Lenders also take into account your income, credit score, payment history, and current debts to assess your eligibility. Like any other secured loans, loans against property are available to borrowers with less-than-perfect scores. Their interest rates usually range from 8.00% p.a. to 25% p.a.
Loans against Insurance
A loan against insurance is when you borrow money using your life insurance policy as collateral. These loans allow you to get a portion of the policy's value. However, only policies with cash value are eligible for this type of borrowing. It's not possible to use term life insurance for this purpose. Interest rates on such options vary by lender, with the average APRs ranging from 10% to 15%. The exact cost will also depend on the terms of your insurance policy, your income, and your credit history.
Loans against Gold
Gold loans are secured loans that allow individuals to borrow money against their gold jewelry or coins. The golden items you provide to a lender serve as collateral and can be repossessed if you default on your loan. The amount you can borrow is the percentage of the assessed value of the gold. It's determined based on its weight, purity, and the current market value of gold. The interest rate will depend on several factors, including the lender's policies and a borrower's creditworthiness.
P2P Loans
Loans available via peer-to-peer platforms come not from traditional lenders but from individual investors. This practice allows you to bypass banks and borrow money from other individuals, often at quite attractive terms. Many peer-to-peer loans don't involve a thorough credit score check. Both secured and unsecured options are usually available. Interest rates vary widely and range from 6.5% p.a. to 15% p.a. You can typically borrow between Rs.25,000 and Rs.10 lakh and repay the funds in affordable EMIs within 3 to 36 months.
Final Thoughts
Both personal loans and credit card loans can provide a lifeline when you need to cover your personal needs. Still, these two options differ significantly. To determine which one to choose, you need to determine your loan purpose and expectations. If you want to finance a big purchase or major life event and split the cost over several months or years, a personal loan may be a perfect fit. Borrowers who are looking for a source of emergency assistance to turn to when needed may consider a credit card to be a better choice. Still, knowing the terms and pitfalls is crucial for your pleasant borrowing experience.