When You Should (and Shouldn't) Take Out a Personal Loan to Pay off Debt
Ballooning credit card balances can feel insurmountable. Case in point: Four out of five Americans in a recent Discover survey say their financial situation causes anxiety and almost a third fear they’ll never get out of debt.
Consolidating your debt through a personal loan could help ease the strain — mentally and financially. While it may seem counterintuitive to take on a new loan when you’re struggling to repay existing debt, doing so could simplify the repayment process and save you costly interest charges.
That’s because a debt consolidation loan replaces your multiple credit card debts with a single new loan that ideally charges less interest. Depending on the term length, it could help you repay the debt quicker or lower your monthly payments, making it easier to manage your bills.
If you’re interested in trying out this strategy to clear your debt, you should understand the potential benefits and risks involved before signing any loan agreement. Here’s what you need to know.
Benefits of using a personal loan to consolidate credit card debt
One payment: Combining multiple credit card debts into a single loan simplifies the repayment process. Instead of keeping track of several cards’ bills each month all with varying interest rates and due dates, you just need to manage one, reducing the risk of missing a payment.
Lower interest rate: Personal loans typically charge lower interest rates than credit cards, meaning you’ll pay less in financing costs while clearing your debt. The average rate on a 24-month personal loan is currently 12.33%, while the average APR on a credit card sits at 21.76%, according to the Federal Reserve. Those with strong credit scores — say, 720 or better — may even qualify for rates as low as 7% on a personal loan. Just be sure to check that any low rate you're offered isn’t a teaser one that will jump up after a short time, advises the Consumer Financial Protection Bureau.
Clear timeline: With personal loans, the debt must be repaid by a certain date, typically between two and seven years, depending on the lender. Having a set date by which you’ll be debt free can help you see the light at the end of the tunnel and keep you motivated, says Rod Griffin, senior director of public education and advocacy for credit bureau Experian. Credit cards, on the other hand, lack a set payoff date and borrowers can tap into their credit limit anytime while making only small monthly minimum payments, so it can be harder to figure out when you’ll be debt free (and easier to increase your outstanding balance).
Consistent repayment schedule: You’ll make one predictable monthly payment that won’t change if you choose a personal loan with a fixed interest rate. This makes it simpler to budget for than credit card repayments, which can shift month to month as your balance fluctuates and the variable interest rates they typically charge change. So unlike with credit cards, borrowers know upfront exactly what interest rate they’ll pay, the size of their monthly payment and how many months it will take to be debt free. (Note that if you opt for a personal loan with a variable interest rate, your payments may change like with a credit card.)
No collateral required: Because personal loans are a form of unsecured debt, you do not need to provide collateral like a car, home or other valuable asset to qualify. So if you default on the loan, lenders cannot foreclose on your property or seize your transportation or other possessions as they can with a home equity loan, home equity line of credit (HELOC) or auto loan.
Boost credit score: Revolving debt, like credit cards, tends to more negatively impact your credit score than installment debt like a personal loan. Part of the reason for this is your credit utilization ratio, or how much of your total available credit you’re actively using, plays a big role in your credit score.
When you max out a credit card or come close to a card’s credit limit, your ratio jumps way above the 30% mark recommended by credit scoring models FICO and VantageScore. Converting that credit card debt to installment debt then reduces the number of accounts you owe on and lowers your utilization ratio, providing a “credit score benefit even before you pay down one penny of your debt,” says credit expert John Ulzheimer, formerly of FICO and Equifax. The caveat is this is true so long as you don’t close out your credit card accounts after paying them with the consolidation loan.
Downsides of using a personal loan to consolidate credit card debt
Need good credit for best terms: Many loan companies have a minimum credit score requirement you must meet in order to qualify, typically between 580 and 660. Even if you meet this requirement, you won’t get the lowest rates a company offers if your score is in that range. The best repayment terms go to borrowers with top credit scores, high incomes and low debt-to-income ratios. While some lenders do cater to borrowers with low credit scores, the rates they offer could be above 20% and potentially as high as 36% — leaving you paying more than you currently do on your credit cards.
Fees: Lenders often charge you a fee to cover the cost of processing your loan. These origination fees can range from 1% to as much as 10% of the total loan amount. The fee can either be deducted from your loan balance, reducing the amount of money you’ll receive, or added to your balance, increasing the debt you must repay. You can find companies that forgo this fee, but you’ll typically need a good credit score to qualify for their loans.
Most lenders also charge late payment fees and non-sufficient funds fees. Prepayment penalties for paying off the loan early are uncommon, but you’ll want to keep an eye out to make sure the lender you choose doesn’t have them.
Chance of higher monthly payments: Depending on how much you borrow to consolidate your credit card debt and the loan term, your monthly payment could total more than the minimum payment your credit cards currently require. The shorter your chosen repayment timeline, the more likely this is to happen. For instance, if you borrow $10,000 at a 12.33% interest rate and repay it in two years, your monthly payment will be $472. Increase the loan term to four years and the monthly payment drops to $265. Of course, the longer the loan, the more you’ll pay in interest over time.
Minimum loan size: Loan companies usually require that you borrow a certain amount in order to qualify for a personal loan. Depending on the lender this amount could be small, only $1,000, or a bit more, like $5,000 or higher. Be sure a lender can meet your needs to avoid borrowing more than you want and paying unnecessary interest charges.
Temptation to spend: Shifting your debt to a personal loan frees up your existing credit cards, allowing you to potentially run up large balances again if you’re not mindful of your spending. Do this and you’ll be in debt twice over, warns Ulzheimer.
No payment flexibility: Once you’ve agreed to a personal loan amount and term, you're tied to that payment until the loan ends. You cannot borrow more or pay a different amount each month as with a credit card. So if you like having the option to drop down to the minimum payment on a credit card when needed, a personal loan’s rigid schedule likely won’t suit you. Some lenders may have a forbearance option where you can temporarily postpone your payments, but these will vary by lender and typically require some demonstration of financial hardship.
Should you use a personal loan for debt consolidation?
Even with the potential downsides, experts typically see using a personal loan for consolidation as a smart move.
It often makes sense to use a personal loan to pay off credit card debt, Ulzheimer says. “You’re converting credit-score damaging revolving debt into score benign installment debt and APRs on personal loans are almost always lower than rates on credit cards so they’re less expensive.”
Still, before taking out a personal loan to consolidate your debt, you’ll want to be sure your credit score and history qualify you for a lower interest rate than what you currently pay on your credit cards. You should also check that your interest savings won’t be entirely eaten up by origination fees, otherwise the move won’t improve your financial situation.
Even if you have a high credit score and lenders offer you favorable repayment terms, review your budget to be sure you can handle your new payment obligation each month before signing any loan agreement.
“If you are truly committed to not using your card to add to your debt and can make monthly payments on time then you can consider using a personal loan to pay off debt,” says Melissa Caro, a certified financial planner with FBN Securities in New York City.
Alternative debt consolidation options
Those with excellent credit and small amounts of debt or enough spare income to clear their balance in less than two years will likely do better with a balance transfer card rather than a personal loan. Credit card companies typically give new balance transfer card users an introductory 0% financing window of between 12 and 21 months. During this period, no new interest charges accrue on the debt you shift over from your existing cards, providing a unique opportunity to clear your balance without it growing. But you need to be disciplined. If you fail to pay off your balance before the 0% promotional rate ends, the high standard interest rates these cards charge could leave you in a worse position.
If you own a home and have at least 20% equity built up, consolidating your debt through a home equity loan or home equity line of credit (HELOC) could be the smarter financial move. Interest rates currently average about 8.5% — far less than the typical personal loan or credit card charges — because your property acts as collateral. (Though this also means lenders can foreclose on your home if you default.) Depending on the lender, you may be given a loan term ranging from five to 30 years, providing more time to pay off your debt and potentially get a lower monthly payment than you could with a personal loan.
Qualifying may be tricky for those with lower credit scores as most lenders prefer applicants with scores of at least 620 and a debt-to-income ratio of 43% or less. These loans also typically come with closing costs or origination fees of between 2% and 5% of the total borrowed amount. Using this option could force you to borrow far more than you need to pay off your credit card debt as some lenders require a minimum loan size of at least $35,000.
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