There are two types of financial products when it comes to loans for personal use, and these are personal loans and credit cards. People often have doubts about these, they do not know which of these two options would suit them best, and they do not understand the differences between the two.
If that is your dilemma or confusion, in this article we will talk about the differences between having a personal loan and a credit card. And no, they are not the same thing, although they are relatively similar.
But before getting into loans, it is necessary that we cover a very important topic, and that is the FICO.
What is the FICO and the FICO Score?
In the United States, the FICO is a type of credit score. Financial institutions leverage the FICO score to learn about you – they want to see how you manage your credit and debt.
The FICO has a percentage distribution that defines your score. The breakdown is as follows, 30% corresponds to the amount you owe, your total debt. Another 35% is defined by payments, that is, how timely you are making your monthly payments. Another 10% has to do with new credit, that is, every time you apply for a loan, either for a credit card or for a personal loan.
Then, we have 15% allocated to credit length, which has to do with the time you have had credit: two years, three years, four years, five years, or more. The remaining 10% has to do with credit mix, and that is precisely what we will focus on in this article.
The first thing you should know is that a personal loan is a type of credit, and a credit card is another type of credit, just as a mortgage is a type of credit. All that mix of different types of credit is what makes up your credit mix.
The main distinguishing factor between a personal loan and a credit card, is that a personal loan has a term. It can be three, five, or sometimes, if you are lucky, you can get a loan for a duration of 10 years.
On the other hand, credit cards don’t have a term as they are “revolving” debt. Think of a credit card as the revolving doors you see at the entrance of buildings, they do not stop rotating.
Why is it called revolving?
With a personal loan, once you are approved for one, everything is there. Let’s assume that the bank approved you for a credit line of $10,000. You use that money for whatever you want: renovate the kitchen, build a pool, cover an emergency, pay for college, or whatever you need. There are no restrictions on the use of that money.
When a personal loan of $10,000 is approved, your payments begin the following month. Let’s say you have to pay $300 every month for five years. When you finish paying your debt, everything is done, the line of credit is closed, and the debt will appear as closed on your credit history. Your credit report will show evidence that you had a loan, and you paid it back.
If you need another line of credit in the future, what you will have to do is go to the bank and reapply for a line of credit to be approved. On the other hand, things work differently with a credit card. Let’s say you have a credit card for $10,000, you can use the entire $10,000, or make payments for $2,000, $1,000, $500, whatever amount you want (as long as it is equal to or above the minimum payment required). As you pay off that card, the balance or debt goes back to zero, and then you can start using the card again.
Another difference is that credit cards don’t expire. What expires is the card, and when the plastic card expires, the bank sends you another new card so that you can continue using the avalailable credit, but that history, that capital, those $10,000 that you were approved for, they don’t expire, unless you decide to close the credit card and cancel that account.
The biggest benefit of having a credit card is that you don’t have to apply for one over and over again to receive money. You use the credit available in your card, you pay it off, it goes to zero, and then you have the $10,000 card again. That is why it is called a revolving line of credit.
Using loans and credit cards together
There is a technique that many people apply to use these two types of loans in a complementary way. For example, let’s assume you have a credit card debt of $20,000. That debt clearly affects your credit score, since it represents 30% of your FICO Score.
What many people do is that they simply take out a personal loan, since it is a different type credit, and use that money to pay off the credit card debt. After a few days or weeks of doing that, your credit score automatically goes up.
In terms of interest rate, we can say that the value is relatively the same. Most of the time, personal loans start at a rate of 24.99%, while credit cards generally start at a rate of 15.99%.
At first, it seems that one would be paying more interest with personal loans, but it all depends on the credit profile of the person. There are people who have a lot of debt, lots of credit cards, and because of that, they are not going to have an interest rate of 15.99% in their credit cards.
There are people who can even have an interest rate as high as 24.99% (or even higher) because maybe they damaged their credit, they did not handle it in the correct way, and that is why they are caught in a high interest bubble.
Personal loans or credit cards: which one is better?
Well, it will all depend on the financial situation of each person. Using a personal loan means that every time you need money and want to use a personal line of credit, you have to go to the bank, apply for a new line of credit, fill out forms (with lots of questions), and more. In that respect, personal loans seem a bit inconvenient.
On the other hand, with a credit card, you apply for it only once, the bank approves your application, and your only responsibility is to maintain that credit, that is, pay it on time and make sure you keep a good credit score. Another reason to use credit cards is that you can have many and the limit is set by your credit profile.
Both, personal loans and credit cards, are great resources to build your credit and will help you demonstrate that you know how to handle your credit responsibly. These are both excellent resources to leverage depending on your financial needs.
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