If you are deep in credit card debt and struggling to climb out of the hole, a personal loan might seem like a good way to turn around a bad situation. A personal loan is a lump sum of money that you borrow from a bank, credit union or online lender and pay back in installments over a fixed period. You repay the loan with interest and can use your funds for many purposes, including consolidating debt.
“If your spending is completely under control and you’d like to save some money while paying down debt, a personal loan can work,” says Martin Lynch, president of the Financial Counseling Association of America.
Before you use a personal loan to pay off your debts, though, make sure you understand the pros and cons of this approach.
Personal Loan Debt vs. Credit Card Debt: Which Is Better?
A personal loan or a credit card can be a good option, depending on how much money you need and how quickly you can pay it back. Generally, personal loans are best for a large expense or debt consolidation, while credit cards are ideal for smaller everyday purchases. Both types of debt have pros and cons.
Personal loan pros
— Lower costs. “In general, if you have good credit, personal loans have lower interest rates than most credit cards,” says Amy Maliga, former financial educator at Take Charge America, a nonprofit financial counseling agency.
— Higher limits. You can often get a personal loan in a much larger amount than the limit you can expect on a credit card.
— Fixed payments. Unlike a credit card — which is a type of revolving credit, with payments that can change from month to month — a personal loan is an installment loan. “With an installment loan, you know the due date. You know the amount of each month’s payment,” Lynch says.
Personal loan cons
— Fees. Lenders may charge fees and prepayment penalties, plus borrowers with low credit scores can pay high interest rates.
— Fixed payments. No, it’s not a typo. Fixed monthly payments might not appeal to everyone. Some people prefer the flexibility to choose how much to repay on a credit card, as long as they meet the minimum monthly payment.
Credit card pros
— Debt transfer. You may be able to transfer your debt to a card with a 0% introductory APR, buying you at least six months to pay down your debt and avoid interest on your balance. Also, a card is revolving credit, which allows you to access up to your credit limit and reuse it as you pay down the balance.
— Rewards. Credit cards can offer cash back rewards, miles or points as money-saving incentives for spending. Credit cards are also generally safer and more convenient to carry than cash.
Credit card cons
— High interest rates and fees. Credit cards are a relatively expensive form of debt because of high interest rates. Other drawbacks include the potential for overspending and the fees that can come with credit cards, such as annual fees, interest charges, late payment fees and more.
Pros and Cons of Using a Personal Loan to Pay Off Credit Cards
Pros
— You could reduce your interest rate. Make sure you can qualify for a low-interest personal loan. “The benefit is paying off a balance at a much lower interest rate, which can save you quite a bit right now,” says Lynch, who is also compliance manager and director of education at Cambridge Credit Counseling Corp. in Agawam, Massachusetts.
— You could get out of debt faster. The money you save on interest might help you clear your debt more quickly, says Alli Wetzeler, a credit counselor at Consumer Credit of Des Moines. “Especially with credit cards, if you have a really high interest rate and you are paying just the minimum every month, it can take many years to pay them down.” FC: https://www.linkedin.com/in/alli-wetzeler-48bb681b9/
— You could boost your credit score. Paying off credit card balances lowers your credit utilization ratio, an important factor in your credit score. “If you have several credit cards that have high utilization, this can be hard on your credit score,” Wetzeler says. “Paying those off can help bring that percentage down, and your score can go up.”
— You can streamline your monthly payments. Rolling your debts into a single loan payment can help you reduce the stress of managing multiple bills and due dates. “It can be easier to budget for paying back a personal loan because you know what the payment will be each month,” Maliga says.
Cons
— You may not qualify for a low rate. This is possible if you are deep in debt and have other blemishes on your credit report. “If you have a lower credit score, then your personal loan rates may be really high,” Wetzeler says. Or you may not qualify for a large enough loan to pay off all of your debts.
— You could end up worse off than when you started. Falling behind on loan payments could mean late fees, missed payments reported to the credit bureaus and hits to your credit score. Fail to pay and you could even lose collateral if the loan was secured, Lynch notes.
— You haven’t solved the root problem. Taking out a loan to pay off credit cards will leave your cards with a zero balance, and you might be tempted to use them. But that can dig an even deeper hole. “It doesn’t address the original problem,” Wetzeler says. “This could result in an even more difficult situation.”
How to Choose the Best Debt Consolidation Lender
Research and compare lenders to choose the right one for your debt consolidation loan. Look for lenders that allow you to prequalify for a loan to check your approval odds and potential rates.
Each lender has its own criteria for determining that you’re creditworthy. A lender might evaluate your credit score, credit history and income, for example.
“Shop around for the lowest possible interest rate,” Maliga says. “Remember to consider loan origination fees and whether there are penalties for paying off the loan ahead of schedule.”
Interest rates on personal loans can be either fixed or adjustable. Make sure you understand the option that makes sense for you. “If you opt for a fixed rate, you’re not as vulnerable to the kind of interest rate increases we’re currently experiencing,” Lynch says.
Review the lender’s policies and ask questions, Lynch says, including:
— Is paying down a credit card balance an acceptable use of loan proceeds?
— Does the loan have closing costs or loan origination fees?
— Is a minimum credit score required?
— Do you charge a penalty for paying off the loan early?
“There are any number of terms or conditions that may be attached to the loan, so a fair amount of homework is required before you apply,” Lynch says.
[Read: Best Debt Consolidation Loans.]
How to Use a Personal Loan to Pay Off Credit Cards
If you are ready to pay off your credit card debt with a personal loan, follow these steps:
1. Compare loans from different lenders. Shop around to find the best terms and interest rates. Sources of personal loans include traditional banks, credit unions and online lenders.
2. Prequalify for a personal loan. Make sure the lender uses a soft inquiry that will not affect your credit score. Many lenders allow you to prequalify online with some basic information to determine your eligibility and estimate loan terms.
3. Apply for the loan. If you are approved, expect to receive your loan funds in one to five business days for banks or credit unions and within the same business day for online lenders.
4. Pay off your credit card debts. This will put your credit card obligations in the rearview mirror, as long as you are careful about not overspending.
5. Make payments on your personal loan. This means you will have a set monthly payment to the lender. One of the best ways to stay on track with your personal loan payment is to set up autopay.
Alternatives to Personal Loans for Paying Off Credit Card Debt
While a personal loan can be a helpful tool in paying off credit card debt, it is not your only option. Some alternatives to consider:
— Talk to your credit card issuer. “You can ask your credit card issuer if they’d consider reducing your rate, which actually can happen,” Lynch says.
— Adjust your budget. Another option is to reduce your expenses, increase your income or both. “Take a second job to generate additional funds to use toward your goal,” Lynch says. “If you have an asset to sell, that can also work.”
— Try a balance transfer credit card. Borrowers with good or excellent credit should shop around for balance transfer offers that feature 0% interest, Maliga says. However, she urges caution before choosing this option. “Do the math to make sure you can pay off the balance in full before the promotional transfer rate expires.”
— Borrow against your home equity. A home equity loan gives you a lump sum, and a line of credit allows you to borrow as needed. The risk is that your home is collateral, which means you can lose it if you fail to pay. Cash-out refinancing also allows you to tap your home equity, but you increase what you owe on the mortgage.
— Opt for a debt management plan. A nonprofit credit counseling agency can help you set up a plan and consolidate your debts into one monthly payment without a loan. Creditors may agree to waive fees, lower payments or reduce rates if you agree to pay through the plan. “Credit counseling agencies deal directly with creditors to secure these extremely low rates that consumers would not be able to negotiate on their own,” Maliga says. A debt management plan can be helpful if you have fair or average credit and can’t secure attractive interest rates on a personal loan or qualify for premium balance transfer offers, she adds.
— Debt settlement. These companies claim they can negotiate with your creditors to reduce what you owe, but the approach can be risky. It can be a last resort if you have an unmanageable amount of debt and do not want to file for bankruptcy.
More from U.S. News
How to Get a Low Interest Rate on a Personal Loan
Should You Get a Personal Loan From a Bank or a Credit Union?
Should You Take Out a Personal Loan to Pay Off Credit Card Debt? originally appeared on usnews.com
Update 03/14/24: This story was previously published at an earlier date and has been updated with new information.
