When you are struggling with debt, the difference between various types of loans, credit cards and other debts can seem small. But, in reality, there are a few big differences between some types of loans and credit cards. Although each involves borrowing money, there are differences when it comes to the amount of interest you end up paying and how the loan affects your credit.
One difference between personal loans, credit cards and other types of loans is that they aren’t all the same type of debt. Credit cards are known as revolving debt. When you open a credit card, you have a set credit limit, such as $1,000. You can borrow up to the full $1,000 on the card, repay it, then borrow another $1,000, repay it, and so on. You can also choose to borrow less than your limit, such as $100.
Other loans, such as your mortgage, a car loan and personal loans, are known as installment debt, meaning you borrow the full amount at the start of the loan, then repay it in predetermined monthly amounts. If you’d like to speed up the rate at which you repay an installment loan, you have the option of making additional payments each month, although some lenders do charge a penalty for doing that. Once you have paid back the debt you borrowed, you do not have access to the original amount of the loan for borrowing in the future.
The interest rate charged is typically different between credit cards and loans. For example, mortgage interest rates tend to be in the single digits, while a credit card interest rate can be above 20 percent.
It’s worth noting that a higher interest rate doesn’t necessarily mean a loan is more expensive. While your credit card might have an annual percentage rate of 18.99 percent and your mortgage has a rate of just 4.5 percent, your mortgage can be the more expensive loan. If you use your credit card and are able to repay the balance in full before the end of the grace period, you won’t be charged interest. There’s usually no grace period on installment loans.
The reason why many loans, such as a car loan or mortgage, have lower interest rates associated with them than credit cards is because typically loans are considered a “secured debt” meaning, if you default on the loan or don’t pay it as agreed, the lender has an asset or collateral they can take to offset the loan. So, if you purchase a car and don’t pay the loan as agreed, the lender can reposes the car to recoup at least some of their investment. have collateral. If you don’t pay your mortgage, a bank might foreclose on your home. Unsecured personal loans and credit cards usually don’t have collateral, which is part of the reason why their interest rates tend to be higher.
Any type of debt, whether a loan or a credit card can have a negative impact on your credit score if you accumulate too much debt or fail to pay your lender as agreed. Late payments or default have a tremendously negative impact.
The way a loan impacts your credit is also slightly different than a credit card. If you borrow a lot of money on a credit card, you affect your credit utilization ratio, meaning it looks as though you’re using a lot of the credit available to you, which can be a red flag to lenders that you are over extended and aren’t using credit wisely. With an installment loan, your credit utilization ratio wouldn’t be affected in the same ways, although applying for the loan would affect your credit. If you paid the installment loan as agreed, the impact on your credit would be less than with a credit card.
If you feel overwhelmed by your debt or need assistance when it comes to working with your creditors, we can help. CESI offers non-profit credit counseling and debt management plans that help you get your financial life back on track. To learn more about how we can help, contact us today.
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