Borrowing money is a big decision to make, but what’s more complicated is not knowing which finance product is best for you.
There’s a whole host of factors to consider, from the speed with which you get the money, to the interest you’ll pay and your financial habits. Just because one method suited you in the past, doesn’t mean it’s the right one for the situation you’re now in.
Two common forms of borrowing are a personal loan or a credit card. Both have advantages in the right circumstances. But which is the best for short-term borrowing? Here we explain the pros and cons of each.
Should I go for a loan?
A loan is borrowing a set amount of money over a fixed period. You will be offered a specific interest rate, and then a contract is drawn up where you have to pay a fixed amount back regularly (usually monthly).
A personal loan is often the fastest way of borrowing money. As soon as a lender agrees to lend to you and you’ve signed the credit agreement, they will usually transfer the sum instantly, so the funds can be in your account the same day, sometimes as quick as within an hour. However, this may vary depending on whether your bank accepts faster payments.
Here are some other benefits of a loan compared to a credit card:
- The interest rate you’re offered may be lower than on a credit card, although this will depend on your credit rating.
- Because you pay a fixed amount each month, you can’t continue to rack up borrowing with loans. This makes you less likely to fall into persistent debt.
- Often, you can pay back extra whenever you want, just like a credit card. It’s illegal to charge a penalty for any extra repayments up to £8,000 in a year, and even if you do go over that amount, the charge can’t be more than 1%.
- The amount you borrow is free to use as you see fit (as long as it’s not for anything illegal). So you’re charged the same interest rate whether you use it for a variety of reasons. It’s worth noting though, you’ll generally need to state your loan reason on the application.
There are pitfalls with borrowing via this way, however:
- You have to pay a specific amount each month. This won’t change, compared to a credit card which will get lower the less debt you have.
- There is no flexibility with what you borrow, so you can’t access more money once you’ve paid some off. To do so, you will need to apply for another loan.
- You can pay more than the set amount each month, but it must be on top of your contractual payments. So if you pay £20 before your monthly payment of £100 is due, you must still pay £100 and not £80.
Or perhaps a credit card?
Credit cards are a form of revolving credit. This essentially means you can control how much of your debt you pay back, from the minimum payment right up the full amount.
For this reason, credit cards are one of the most flexible forms of borrowing. You can borrow however much you want within your agreed limit. Plus you can pay as little or as much of it back at any time, as long as you meet the minimum repayments each month.
There are other benefits for borrowing with a credit card, including:
- You don’t get charged interest on your credit cards straight away. There’s a grace period (between 26-56 days) where you aren’t charged interest on your purchases.
- If you have a good credit rating, you may be offered an introductory offer for a set amount of time. This can mean little or no interest at all on purchases, cash transfers or balance transfers (however, there may be a balance or cash transfer fee).
- It’s possible to borrow money on a credit card and never pay interest. To do this you will need to clear the balance in full every month. Or pay off any transactions not covered by any introductory interest-free offers each month. Then pay the ones that are included before the offers expire.
- You just need to meet the minimum payment each month but you can pay any amount back between that and the full balance. You aren’t charged penalties on this, even if your credit limit is above £8,000 (unlike a loan).
Despite this, there are some negatives with credit cards. These are as follows:
- If you don’t already own a credit card, it can take up to two weeks for it to arrive once your application has been successfully accepted, which slows down access to your money.
- They are usually only good for purchases. Withdrawing cash comes with extra interest charges, and this isn’t covered under the grace period or 0% introductory offers.
- Typically, credit cards have higher standard interest rates than loans. This will depend on your credit rating and the lender, however.
- If you miss a payment, you may lose any introductory offer rates you have been given.
- The flexibility can also tempt you to borrow more and pay back less. If you continue to pay back only the minimum amount each month, you run the risk of getting into persistent debt.
How is my credit rating impacted?
If you borrow money and pay it back as per the contractual agreement, borrowing either by a loan or a credit card will eventually improve your credit rating. But there are some nuances which can influence your credit rating in different ways.
- If you already own a credit card, you can borrow on it without making a credit application (you will need to for a loan, however). This means there will be no short term impact on your credit rating.
- Lenders assess your affordability when deciding. They could view your higher contractual payments on loans as more damaging for this (compared to credit cards), as you will have higher outgoings.
- But, they may also look at the total credit limit available to you as more of a risk with credit cards. This will depend not only on your borrowing past but the lender’s requirements and the current financial climate.
- Your credit rating is affected by your credit utilisation, which is the percentage of how much you have borrowed out of your credit limit. A lower credit utilisation of your credit cards is good for your credit score, whereas anything over 30% can have a negative impact. A loan doesn’t contribute to your credit utilisation rate.
What about overdrafts?
Another form of revolving credit is an overdraft, which can also be useful for short-term borrowing. However, unlike credit cards, you are charged interest straight away on your overdraft. The rates are often now around 40% which makes them one of the most expensive forms of borrowing.
For this reason, overdrafts are good safety measures for you to borrow on a short-term basis only, particularly within a week before you are due to be paid. They are not cost-effective long term borrowing options though and can impact on the likelihood of you being offered a mortgage.
So, which should I go for?
The best option for you depends on the answers to three questions: how much you need to borrow, how quickly you need the money, and how soon you plan to pay it back.
Smaller amounts of money that you can pay back within up to six months are potentially better suited to credit cards, particularly if you own one already.
But if you need the money straight away, a loan may be a better option as they can provide instant funds. And whilst they are better for longer-term borrowing, depending on the interest rates you are offered, they may be cheaper over even a short-term period.
Ultimately it boils down to your own circumstances. Understanding whether flexibility is a good or bad thing for your financial habits and calculating how much interest you will pay over the time you aim to borrow the money for. And remember to weigh up the impact that each choice will have on your credit rating too.
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