Advantages & Disadvantages of Short Term Loans Over Credit Card Use

By John Walton

  • Overview

    Credit cards, instant personal loans and bank personal loans all have one thing in common: they are forms of unsecured credit. Past that, they have little in common. Understanding the different strengths and weaknesses is essential to sound money management and to making good decisions about credit use.
  • What is Unsecured Credit?

    Unsecured credit is not backed by any form of collateral. For example, when you take out a home mortgage it is a secured loan, because your house is the collateral--the bank will seize that and whatever equity you have if you default. An unsecured loan has no such guarantee, so the terms (that is, the interest rate) are not as favorable. Once upon a time, unsecured credit was synonymous with the bank personal loan, but as the credit card business is more profitable, and most banks are in the credit card business, bank personal loans have become less common and this is no longer the case.
  • Personal Loans

    Personal loans are unsecured loans given by a bank, and they are usually based solely on the credit rating of the borrower. On the upside, they typically have lower interest rates than credit cards; the average rate for personal loans in 2008 was 11.9 percent, and the average for credit cards was 13.9 percent. They are given on terms of fixed payments for a fixed duration, which is less misleading than credit card minimum payments, but also not as flexible. On the downside, getting one isn't easy, and usually involves a good bit of legwork in making visits to banks and negotiating terms in person.

  • Instant Personal Loans

    The Internet has granted access to a financial product called the "instant personal loan." Gaining access to this kind of credit is usually pretty easy, since a credit check is rarely required. However, qualifications for approval often include regular employment and income. Once these two matters have been verified, the loan is given. Some lenders may require a phone conversation to clarify final issues before confirmation. Sometimes this can be done on the same day as the application, so while not quite "instant," it is very quick. Interest rates on a legitimate personal loan of this type should be less than or equal to a credit card rate, which is appropriate since they are fundamentally the same form of credit. An instant personal loan's sole advantage over credit cards is that it may have a lower interest rate. There is also the neutral consideration of fixed payments for a fixed duration, as described for the bank personal loan above.
  • Credit Cards

    The first big difference between credit cards and other forms of unsecured loans is that they are not necessarily short-term. A credit card represents an open line of credit; rather than borrowing a fixed amount, you borrow as much as you like up to a limit. This amount is repaid by installments, just as with any other multi-payment loan, except that the amount you pay back is based on the outstanding balance, which can change with purchases. The upside is that an open line of credit is very convenient and very flexible, making it easy to use for unexpected and urgent problems. The downside is that the interest rate will typically be higher than for a personal loan. Also, the minimum monthly payments are aimed mostly at servicing interest charges, and not paying down debt. This makes them misleading.
  • Warning: Payday Loan

    Some instant personal loans are really "payday loans," unsecured small loans, with repayment due in about 2 weeks. The interest rate varies with local law, but rates as high as 30 percent for a 2-week period are not unusual. Expressed as an APR, 30 percent for 2 weeks is almost 800 percent (contrasted against credit cards, which rarely exceed 25 percent APR). This practice is illegal in Georgia, and it isn't feasible in 12 other states due to restrictive laws. A variant of the payday loan is the income tax refund loan. Credit reports are never a consideration for loans of this type, and given their disadvantages they should never be sought by people with other alternatives.
  • Credit Card Balance Transfers

    Balance transfers can be a good way to consolidate credit card debt, as credit card companies sometimes offer special balance transfer APRs that are more advantageous than even the most generous personal loan. Balance transfer offers of 3.9 percent for 3 years are uncommon, but not unheard of, and anyone who can get terms like that from a bank doesn't need to borrow the money. If a borrower can consolidate all or most of his debt under one lower interest rate, it will allow him to pay that debt down more quickly, because more of his payments go toward the principal, and less toward interest.
  • Expert Insight

    If you can plan ahead and anticipate your borrowing, then you should go the personal loan route if you can. The lower interest payments make it worthwhile. Do not pay things like medical bills, covering the mortgage after losing a job, and so on with a credit card when a personal loan can be had. However, personal loans take a lot of work to get for anyone not on a first name basis with his local banker. For unexpected situations that require some borrowing, a credit card can be invaluable. Finally, if one is looking to consolidate debt but has some time to wait for a good deal, keep an eye out for a balance transfer offer at a very low interest rate and for a duration of 2 or 3 years.
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