Is a credit card or personal loan the better way to cover an expense, especially an emergency bill that comes out of nowhere?
The best answer is that bills are best paid from cash and not from borrowing. Unfortunately, millions of people lack savings.
Speaking on CNBC earlier this year, JPMorgan Chairman and CEO Jamie Dimon said “it is absolutely obvious that a big chunk of [people] have been left behind. Forty percent of Americans make less than $15 an hour. Forty percent of Americans can’t afford a $400 bill, whether it’s medical or fixing their car.” (parenthesis his)
“When faced with a hypothetical expense of $400,” explained the Federal Reserve in May, “61% of adults in 2018 say they would cover it, using cash, savings, or a credit card paid off at the next statement.”
Credit card or personal loan versus payday lender
What about the other 39%? What will they do? They will get the money somewhere else. In many cases that means using a payday lender. This is an extremely expensive way to borrow money. A study by the Consumer Financial Protection Bureau found that the typical payday loan was $392. It also found that the average interest rate was 339%.
Rather than a payday lender, a credit card or personal loan can be a better option for a surprise expense. They are far cheaper than payday financing and if you make your payments you can improve your credit score.
Credit cards and personal loans are both extensions of credit. They differ in the way borrowers are allowed to access cash.
A credit card is a form of revolving credit. A borrower may take out funds at any time up to the credit limit. There are minimum monthly payments based on the loan balance. However, the balance can be repaid at any time in whole or in part without penalty. It is possible with credit cards to buy goods and services, pay with credit, and not face any interest charges by paying the debt in full each month.
While you can pay for goods and services with a credit card and not pay any fees the merchant does pay each time a card is used. If you use a credit card to pick-up cash there’s typically a cash advance fee. The fee can be either a flat charge or a percentage of the amount borrowed.
Credit cards can be enormously handy. The reason is that such accounts are typically established before a financial emergency arises. To cover a cost all you have to do is use your credit card. You don’t have to quickly apply for a loan. You don’t have to worry that your application might be denied. With a credit card you have the ability to take on a surprise expense.
Banks love credit cards. A 2019 Federal Reserve report explains why.
“Credit card earnings have almost always been higher than returns on all commercial bank activities,” the Fed explains. “Earnings patterns for 2018 were consistent with historical experience: The average return on all assets, before taxes and extraordinary items, was 1.46 percent for all commercial banks, compared with 3.79 percent for the large credit card banks.”
While a credit card balance may move up or down, with personal loans size of the debt is always being reduced. That’s because a personal loan is really just an extension of credit in the traditional sense. You might get a $5,000 personal loan and agree to repay it over four years with fixed interest a 10%. The monthly payment for principal and interest will be wondered and $126.81. At the end of four years the debt will be completely repaid.
Typically you apply for a personal loan from a bank, credit union, or friends and family. This can take time. That’s a problem if you need the money quickly. Also, you might get turned down. In that case you still have the expense to deal with.
How much does it cost to borrow money with a credit card or personal loan? The general answer, according to the Federal Reserve, is that credit cards are significantly more expensive. As of May the Fed says credit cards typically had a 17.14% interest rate. Personal loans during the same month were priced at 10.63%.
Credit card or personal loan security
Neither credit cards more personal loans are secured financing. Instead, such credit is offered largely on the basis of your good name. In other words lenders look at your credit scores, debt to income ratios and other financial factors.
This makes credit card and personal loan borrowing very different from mortgages and auto loans. They are unsecured financing. If you don’t make a payment for a credit card or personal loan no one will repossess your car or foreclose your home. Instead, late payments and missed payments can result in fees and charges. There will be credit score reductions. Ultimately, if you don’t repay the creditor might sue or turn the account over to a collection agency.