If you are up to your eyeballs in credit card debt, you might consider consolidating your debt with personal loans. There are several advantages to using personal loans including smaller monthly payments and lower interest rates. Are personal loans really the best way to pay off credit card debt?
What is a Personal Loan?
A personal loan is a loan that your personal bank or credit union will issue. It is also possible to secure a personal loan with peer-to-peer lending if you don’t want to borrow money from a bank to get a potentially lower interest rate and avoid a “hard” credit report inquiry.
Personal loans can be used for just about purpose. Some of the possible reasons to get a personal loan include credit card consolidation, refinancing student loans, remodeling your house, or taking a vacation.
The bank or potential lender might ask you what you intend to use the loan funds for. They can possibly be more willing to approve your request for refinancing debt than borrowing money to go on vacation.
Advantages of Personal Loans
There are two primary reasons why you might consider a personal loan to refinance your credit card debt.
Lower Interest Rate
You can usually expect a lower interest rate for personal loans. A person with excellent or good credit (700+) can expect to receive a rate near 4%. Even someone with fair credit (600+) can qualify for an interest rate of 10% on a three-year term.
That is lower than the average credit card charges an interest rate between 15% and 21%.
There is no guarantee that personal loans will have a lower interest rate. Current banking regulations require the maximum interest rate a local credit union can charge is 18%, which can still be slightly lower than credit card interest rates. But, online banks can charge interest rates as high as 36%!
Smaller Monthly Payments
On the surface, credit cards have a much smaller monthly payment that can be as low as $25 a month. But, a larger portion of the payment is going to accrued interest because of the higher interest rates. Only making the minimum payment keeps your account from defaulting, but, a $2,500 balance can take 13 years to repay at that rate.
Personal loans are fixed loans that require the entire balance to be repaid within a specified time period ranging from three years to ten years. The monthly payment will be higher in order to repay the entire balance on time. This “accelerated” payment schedule means you will pay more each month and pay less in total interest.
Potential Increase in Credit Score
Personal loans can also increase your credit score by consolidating the balances of several credit card accounts. While the record of late payments remain on your credit history for up to seven years, your accounts will be restored to “Current” status. You can start spending on them again (responsibly of course), let them sit idle to keep your available credit ratio high, or close them to remove the temptation of spending.
On-time payments on the personal loan will also build your credit score. Once the loan is paid in full, you should also see a small boost.
Cons of Personal Loans
As with every facet of life, there are negative tradeoffs to using personal loans that can potentially outweigh the positives.
Some Lenders Charge Origination Fees
Some personal loan lenders will charge an origination fee. It can be 1% of the total balance for example. While this concept isn’t unique to personal loans, private student loan companies and balance transfer credit cards have similar policies, it does add to the total cost of the loan.
Interest Rates Could Be Higher
The advertised personal loan interest rates might only be for applicants with the best credit scores. If you have a credit score in the 600s, your interest could be about the same as your credit card is charging. Online lenders can charge interest rates significantly higher than what credit cards charge.
In these instances, it can be more cost-effective to keep the balance on your card to avoid the credit check and potential origination fee, just to save a few dollars with a slightly lower interest rate.
Borrowers with Poor Credit Might Not Qualify
If you have a credit score below 600, you can fall into the “poor credit” category. Lenders might not be willing to offer a personal loan because of the additional risk. If you do qualify for a loan, the interest rate might be higher than your current interest rate.
Alternatives to Personal Loans for Credit Card Debt
Personal loans aren’t the only option to consolidate your credit card debt. You can also pursue the following options:
Balance Transfer Credit Cards
You have probably seen advertisements for these credit cards and potentially received a prequalified offer. The marketing offer for these cards often goes allows 0% APR on all transferred balances for the first 12 months. Some of the best balance transfer credit cards offer no interest up to 21 months!
A few downsides to consider in regards to balance transfer credit cards is that they might charge a small transfer fee that is a small percentage of the transferred balance amount or a flat fee. After the introductory period ends, the remaining balance will be charged the normal credit card interest rate. Finally, you have another credit card in your wallet that can potentially be “maxed out” and increase your debt load.
Credit Consolidation Loans
Credit card companies also offer consolidation loans by partnering with third-party counseling agencies. There are usually fees involved with this process that can make it more expensive than personal loans. You might consider this an option of last resort because of the potentially hefty price tag.
Keep the Balance on the Credit Card(s)
A final alternative is to keep the balance on the credit card(s) with a debt balance. This option can be the cheapest if your credit card has a similar interest rate as a personal loan. Or, if you balance is small enough that it can be repaid within a few short months and the time to transfer is too much of a hassle for the cost-savings.
If you keep the balance on your card, do everything to repay the balance as soon as possible. Make at least the minimum monthly payment to limit the damage to your credit report. Using the debt snowball method to repay the smallest balance first can score a quick victory and maybe even increase your credit score in the process.
Personal loans can be an effective way to pay off your credit card debt. They can not only save you money with a lower interest rate, but, they also give you a payment plan to potentially repay your loan quicker. If you decide a personal loan isn’t the best repayment option for you, that is okay too. There are several good alternatives to repay your debt.