Credit Cards vs Personal Loans vs Payday Loans

Three of the most popular methods for borrowing a bit of extra cash are credit cards, personal loans and payday loans. Each of these loan types have their share of benefits and drawbacks, making them better suited to different financial circumstances.

Before you sign on any dotted lines, it’s worth getting an idea of what benefits each type of loan can offer, and finding out if there are any pitfalls worth keeping an eye out for:

A credit card effectively functions as a flexible loan, allowing you to borrow money from a lender up to a predetermined limit. If you keep up to date with your repayments, you’ll always have the option to use your plastic to make payments in shops, over the phone, or online, even for international purchases and services.

It’s also possible to use a credit card to get cash advances from the bank, a bit like withdrawing money from your bank account via an ATM, though there are often extra costs involved.

Depending on your credit card provider, you may also be eligible to earn additional rewards and benefits by using your credit card, such as free travel insurance, or bonus points that can be redeemed at selected retailers.

Many lenders offer credit cards, from major banks to independent credit providers. To apply, you’ll need some identification and evidence of income, to prove that you’ll be able to pay back any money you borrow from the lender. Your lender will also check your credit history, to determine the level of risk involved in lending to you.

Many lenders charge annual fees on their credit cards, as well as interest. Interest rates for credit cards tend to be on the high side, though depending on how you use your card, you may not always be charged for interest. 

Many credit cards come with a monthly interest-free period on purchases. If you make a purchase on your credit card, as long as you repay this amount before the month’s interest-free period ends, you won’t be charged interest on the purchase. But if an amount is left outstanding, interest will be charged on this remainder, and you’ll lose the interest-free benefit for the next month until the card is full paid off.

Unlike many other types of loan, where you borrow a set amount of money then make steady progress towards paying this amount back plus interest by a certain date, credit cards tend to be a lot more flexible, which can be a problem as well as a benefit.

While you’re encouraged to fully repay your credit card each month, many lenders typically only require that you make a minimum repayment for a small percentage (often just 2%) of the outstanding balance you owe, plus interest charges. If you only make these minimum repayments, you’ll VERY slowly make progress towards clearing your debt, but you’ll likely end up paying a LOT of extra interest charges to your lender. In some cases, it can take decades to pay off a credit card by only making the minimum repayments. 

Also, because a credit card effectively functions as an open-ended loan, even if you’re already struggling to manage your repayments, you may still be tempted to borrow even more money. This could lead to you losing any previous progress made towards repaying your loan, and risking being trapped in a cycle of inescapable debt.

Personal loans are structured differently to credit cards or lines of credit. Rather than offering the flexibility to borrow any amount of money up to a fixed limit, and to then repay what you borrow as you go, personal loans involve borrowing a fixed sum of money that you receive from the lender up front, then making regular repayments over a set term to make sure that this amount ends up fully paid back to your lender, plus interest, on time.

This makes personal loans more useful for making large single purchases, such as buying a car, starting up a business, or paying for a dream wedding. They can also be used to consolidate multiple smaller debts (e.g. credit cards, payday loans) into a single, easy-to-manage loan, so you’ll only need to make the one repayment per month, and only be charged interest the once per month.

Because you can’t typically borrow more money and increase your level of debt with a personal loan, you should be able to make steady progress towards paying back what you owe, with less risk of ending up trapped in a bad financial position.

Personal loans are available from banks and non-bank lenders, including some lenders that specialise in providing personal loans for borrowers with special needs, such as nonconforming personal loans for borrowers with bad credit.

Much like applying for a credit card, when you apply for a personal loan you’ll need to provide your personal details, plus evidence that you’ll be able to manage your loan repayments. Your lender will also check your credit history to determine the risk of lending to you.

Depending on the type of personal loan you apply for, you may also need to provide security to guarantee the sum you’re borrowing. For example, many car loans are guaranteed by the value of the car you’re buying, so if you don’t make your repayments, your vehicle will be repossessed and sold by the lender to cover its losses.

Personal loans typically involve paying interest on the money you borrow, either at a fixed or variable rate. Fixed rates guarantee consistent repayments for the full term of the loan, for simpler budgeting, while variable rate loans usually offer greater flexibility, and may let you enjoy reduced repayments if your lender cuts its rates.  You may also need to pay establishment and/or ongoing fees on your personal loan.

The length of your personal loan term will make an impact on how much it will ultimately cost you in terms of interest and possibly fees. The shorter your loan term, the more expensive your monthly repayments will be, though you’ll pay less in interest and ultimately pay off your loan sooner. A longer loan term can make your monthly repayments more affordable, though the total interest and fees you’ll have paid by the end of your loan may be significantly higher. 

Some personal loans (often those with variable interest rates) include flexible features such as extra repayments and redraw facilities, which may help you to reduce some of your interest costs in the right circumstances.

Because personal loans need to be organised in advance, it’s usually straightforward for borrowers to work out whether they can afford the repayments before they sign on the dotted line. 

If your personal loan has a variable interest rate, there is a risk that the rate could rise, making your loan repayments more expensive. In such a case, you may need to consider the options for refinancing your personal loan, whether with your current lender or a different one.

The greatest risk to keep in mind when you take out a personal loan is being stung with surprise fees, which (depending on your lender) may be charged if you choose to exercise some of your loan’s optional features. You may also be charged penalty fees if you make extra repayments or complete your loan early, to make up for the interest charges the lender will miss out on.

Also, if you opt for a secured personal loan and don’t keep up with your repayments, you may risk losing your security asset, whether that’s your car, your property, or even just a bank deposit.

A typical payday loan scenario goes something like this hypothetical example:

Janice’s family fridge has broken down, right in the middle of a summer heatwave. She needs a new replacement right now, but all the money from her last payday has already been accounted for, covering bills and life’s other expenses. She’d easily be able to afford a replacement in a month’s time, but that’s not going to save the rapidly-defrosting food she needs to feed her family right now.

By approaching a payday lender, Janice can get a small loan approved in a matter of minutes, allowing her to pick up a new fridge the same day and rescue her melting ice cream. When Janice’s next payday arrives, she can pay back the loan, plus any fees and charges, and get on with her life.

Most payday lenders can be quickly contacted by phone or online to make an application. This application is usually faster and less involved than the process of applying for a credit card or a personal loan, though you’ll still need to provide your personal details and some evidence of income to show that you’ll be able to afford to pay the lender back. 

Your payday lender will then confirm your details and perform a credit check. Payday lenders tend to be more flexible around bad credit than many larger lending organisations, but if your credit history clearly shows major financial problems, your application may be declined. 

Once your payday loan application has been approved, you’ll often be able to receive your funds very quickly, sometimes literally within a matter of minutes. 

Unlike credit cards and personal loans, payday loans don’t charge interest on the amount you borrow – only fees. However, these fees are usually listed in percentages, based on the amount you owe, similar to interest rates. 

Current Australian government legislation requires that establishment fees charged at the start of a payday loan can only total up to 20% of the loan principal (e.g. for a $600 loan, there can be a maximum establishment fee of $120). On top of this, the monthly ongoing fees can only total a maximum of 4% (e.g. for a $600 loan, the ongoing fee can be a maximum of $24 per month). Payday loans tend to have fairly short terms, often ranging from as little as 2 weeks to as much as 12 months.

Payday loans provide fast and simple access to money, which can prove very tempting to people who are already experiencing financial stress, and are thus the most vulnerable to extra costs, fees and charges. Even if you only borrow a small amount of money from a payday lender, if your finances are already tight, there’s a big risk of ending up in more debt that you can realistically handle if you’re not careful, or if you experience some bad luck (e.g. having to pay for car repairs after you’ve already taken out a loan for your new fridge). It just takes one missed repayment to find yourself slapped with steep penalty fees, which can quickly add up, leaving you in real financial trouble.

The best precaution when thinking about payday loans is to take some extra time to look carefully at all the terms and conditions involved, work out a budget to see if you’ll be able to realistically afford the extra fees and charges, and decide whether you think these extra costs will be worth it. Taking this extra time to consider your options may mean you won’t get your hands on that money quite as fast as simply applying for a payday loan, but avoiding the extra risk of ending up with problem debt is often worth it. 

Also, try to avoid using payday loans as a “stopgap” solution for managing repayments on larger debts, such as overdue credit cards or personal loans. Borrowing more money could allow you to avoid a late repayment now, but won’t fix the root problem, and could leave you in even more debt trouble further down the line.

If you ever find yourself struggling with any loan repayments, contact your lender to find out your available options. Alternatively, contact MoneySmart for free financial counselling, or call Australia’s National Debt Helpline on 1800 007 007.