Between January and May of 2020, the average American’s credit card debt balance dropped from $6,200 to less than $5,400. It seems that the crazy state of the world has prompted Americans across the board to start making better financial choices.
Are you one of them?
You might still be looking at a few thousand dollars of credit card debt and wondering the best way to pay that down. Have you considered taking out a personal loan to pay off your credit card debt? Is it a good idea?
Let's take a look at the pros and cons of personal loans to pay off credit card debt to help you decide.
What Is a Personal Loan?
Many types of loans have to be used for a specific purpose. For example, mortgages are used to pay for houses, auto loans are used to pay for cars, and student loans are used to pay for tuition and other education expenses.
A personal loan has no such strings attached. When you take out a personal loan you can use the funds for anything. You can pay medical bills, pay for emergency car repairs, pay for your wedding, or simply use the funds to pay for a vacation. You can also take out a personal loan to pay off other debts.
Should I Get a Personal Loan to Pay Off Credit Card Debt?
The question is, should you take out a personal loan to pay off credit card debt? What are the advantages and disadvantages of using this strategy? Let's find out.
Pros of Using a Personal Loan to Pay Off Credit Card Debt
There are a few advantages to taking out a personal loan and using it to pay off credit card debt. However, people with excellent credit scores (or at least good credit) tend to receive the most benefit. Definitely review your credit score and consider your options carefully before applying for a loan.
How many credit cards do you have? The average American has four credit cards. If you use them all, that means you have to make four different payments each month on top of mortgage payments, insurance premiums, utility bills, and other monthly responsibilities. Keeping track can be exhausting!
By taking out a personal debt consolidation loan and paying off all your credit card balances, you go to one monthly payment. Much easier to keep track of.
Lower Interest Rates
Furthermore, personal loans tend to have lower interest rates than credit cards. The average interest rate for credit cards is 20.23% APR, whereas the average rate for personal loans is only 9.41%.
Imagine cutting your interest rate in half! Obviously, with more money going to the principal it will be easier to pay off the balance in full.
Finally, paying less interest typically translates to paying off your loan faster, especially if you make extra payments and don't just stick with paying the least amount possible.
Cons of Using a Personal Loan to Pay Off Credit Card Debt
Of course, nothing is all rainbows and unicorns in the world of finance. There are a few disadvantages to this strategy as well.
Qualifying Could Be Difficult
First up, that lower interest rate that you're banking on may not be available to you. You may not be able to qualify for the loan amount you need or even a loan at all. Auto loans and mortgages come with inherent collateral. In other words, the lender has a physical asset they can seize if you stop paying on the loan. This type of loan is called a secured loan.
A personal loan has no such security, thus the name unsecured loan, so lenders rely more on your credit history. If you have a poor credit score, qualifying may be difficult to impossible.
Taking on More Debt
Another thing to consider is your personal spending habits. If you take out a personal loan, pay off all your credit cards, and then rack them up again, you’ll only find yourself deeper in debt.
If you feel you can’t trust yourself, cut up your cards and throw them away. But don't close the accounts because having them can be beneficial for your credit score.
Interest Rate and Monthly Payment May Not Go Down
If you can't qualify for the more promising personal loan rates, you may find your interest rate and monthly payments do not go down because of the high interest rate. Obviously, this doesn't help your situation and doesn't warrant taking out the debt consolidation loan.
Additionally, credit cards typically don't come with a set debt repayment term. They also tend to charge a rather low monthly payment in comparison to your credit card balance. They do this because they make more money off of you in interest the longer you take to pay off the balance.
A personal loan, however, will come with a set debt repayment period. The monthly payments you have to make to pay off the loan in time could be considerably higher. This is not necessarily a bad thing because the faster you pay off the loan, the more money you save. However, it’s only valid if you have enough money available each month to make the payments.
It is very important to read the fine print before taking out any loan. Most lenders will charge a loan origination fee or some other sort of upfront fee to cover their administrative costs.
If your monthly payment goes down enough to make this worth it, that's not a problem. However, you do need to be aware of the cost of the loan and make your calculations to make sure you would actually be saving money. A personal loan calculator can help you determine the right loan amount and give you an idea of the fees you may have to pay.
Another important fee to be aware of is prepayment penalties. Some lenders will charge you a prepayment penalty if you pay off your loan early to make up for the lost interest. If your payoff strategy is based on early prepayment, you definitely need to know if your lender will charge you.
The good news is that is prepayment penalties are becoming less common. There are a plethora of personal loan options that will allow you to pay off the debt sooner with no penalty.
Will Paying Off Credit Cards With a Personal Loan Help My Credit Score?
Particularly if part of your aim with getting out of debt is to strengthen your credit score, you might be wondering how taking out a personal loan to pay off your credit cards might affect your score. The reality is, this strategy can affect your credit score positively or negatively depending on how you go about it.
Payment history is the biggest factor that affects your credit score, weighted at 35%. Thus, if you take out a personal loan and you make your payments on time, This will help strengthen your credit rating over time.
The reverse is also true. If you don't make your payments on time it will negatively affect your score.
The next largest factor that affects your credit score is your credit utilization ratio. This one is weighted at 30%.
Credit utilization refers to how much debt you have compared to how much credit you have available to you. For example, say that you have a credit card with a credit limit of $5,000. If you owe $2,500 on the card your credit utilization is 50%. If you only owe $1,000 on the card your credit utilization is 20%.
Credit utilization counts across all of your accounts. So let’s say you have two credit cards, each with a $5,000 limit, and they are both maxed out. Your credit utilization is 100%. You take out a personal debt consolidation loan for $10,000 and pay off the credit cards, but don't close them. Now your credit utilization is 0%.
Most experts recommend keeping credit utilization below 30%, and if you want the best score, aim for below 10%.
Should I Pay Off My Personal Loan or Credit Card First?
First and foremost, always pay all your minimum payments each month. After that, let your interest rates decide which of your debts you should focus on paying off first.
Credit cards typically have a higher interest rate so you may want to attack those first. Paying down credit cards also brings down your credit utilization, which helps boost your score.
Best Ways to Secure a Personal Loan
The Internet is a fabulous resource when it comes time to take out a personal loan. Many platforms allow you to put in your details and get instant rates and loan offers from several lenders.
Online lenders usually have less overhead and brick-and-mortar businesses and tend to have lower origination fees, lower or no prepayment penalties, and lower fees in general. The downside is that you don't get to talk directly with a loan officer although many online lenders give you the option to call or chat if you have questions. Online lenders also tend to be more forgiving and make loan offers to even borrowers who have bad credit.
Other options for taking out a personal loan include going straight to a bank or your local credit union. As not-for-profit organizations, credit unions typically have lower fees and offer lower rates than banks.
The main thing is to ensure that you shop around and make sure that you are getting the best loan for your needs. Always read the fine print and understand the fees, penalties, and complete terms of the loan.
Taking Out a Personal Loan to Pay Off Credit Card Debt
So, should you take out a personal loan to pay off your credit card debt? The answer is, it depends. We hope this article has helped you decide if this is a good way to manage your credit card debt.
For more great financial advice, check out more of our articles!