Consolidating credit card debt with a personal loan means taking out a new personal loan, using the loan proceeds to pay off credit card balances and then paying off the new loan. Consolidating accounts with a personal loan can help you get out of debt faster, as long as you have a solid plan for paying it off.
[Read: Best Low-Interest Personal Loans]
Is a Personal Loan Better Than Credit Card Debt?
Personal loans have a few advantages over credit cards, but only for people with certain spending and repayment habits. So, when is a personal loan better than credit card debt?
Terry and Linda Vergon are the co-founders of FrugalGnome.com, a personal finance education site, and they often address debt consolidation concerns with their clients. When deciding if personal loans are better than credit cards, the couple says that it depends on the circumstances.
“The whole reason to consolidate credit card debt into a personal loan is to get into a stronger financial position by reducing the interest being charged on your balances. For this transaction to work in your favor,” Terry says, “it must lower the overall cost of interest or increase your discretionary income (income left over after covering necessities) to a level where you can easily handle a typical financial emergency.
“For example, if your discretionary income goes from $200/month to $400/month as a result of consolidating the debt, then you could handle an unexpected cost like a flat tire or a trip to the urgent care facility.”
Personal Loan Advantages
— One payment. When you replace several debts with one, it’s easier to track your bills, and there’s less chance of missing a payment.
— You know when your debt will be repaid. Credit cards are revolving accounts with minimum payments designed to maximize the amount of interest you pay. Personal loans, however, are installment loans, which means you can’t add to your balance and will pay them off during the loan term.
— Improved credit score. Linda Vergon says that adding a personal loan drops your overall credit utilization, improving the second-most-important factor in calculating your credit score. This can boost your score significantly and quickly.
— Pay less interest. Personal loan interest rates run lower — close to 10 percentage points lower on average in recent years. And by clearing your balances faster, you’ll save even more.
— Fixed interest rate and payment. Personal loans usually come with fixed interest rates and payments that don’t change. This makes budgeting easier.
However, these advantages only apply if you carry credit card balances in the first place, if you can afford the personal loan payment and if you refrain from carrying credit card balances in the future.
[Read: Best Personal Loans.]
Personal Loan Drawbacks
— Higher payments. You’ve probably seen articles that say it takes decades to pay off a credit card balance if you only pay the minimum. That’s because minimum credit card payments are not designed to clear the debt quickly. Personal loans are set up to be paid off by the end of a specific term, and that can push their payments higher than credit cards — even if their interest rates are much lower.
— No rewards. Personal loans don’t offer the rewards, convenience or buyer protections that many credit cards come with.
— No interest savings unless you carry a balance. If you’re a credit card user who rarely or never carries a balance, there’s no advantage to using a personal loan instead.
While personal loans aren’t right for everyone, they are popular for consolidating credit card debt for a reason. Here’s how to consolidate debt with a personal loan.
8 Steps: How to Use a Personal Loan to Pay Off Credit Card Debt
Consolidating debt with a personal loan (or any loan) comes with a few pitfalls you’ll want to avoid. And you can by working through these steps.
No. 1 List Your Debts
It’s crucial to know where you’re starting from so you can chart your course. Grab your credit card statements and list this information for each account:
— Current balance
— Interest rate
— Minimum payment (or the payment that you’ve been making)
Total all of your balances and payments. You’ll want this information to compare your consolidated payment with what you’re paying now. You may also have to decide which accounts to consolidate and which to leave alone if you can’t borrow enough to cover all of your balances, or if any of your cards have a rate that’s lower than the personal loan rate you’re offered.
No. 2 Check Your Credit Score
This helps you avoid applying with lenders with minimum credit scores that are higher than yours. Checking your credit score is also a great way to track credit score improvements as you clear your balances and pay off your consolidation loan.
“Many lenders don’t have specific income requirements, but many lenders prefer to see a credit score in the mid-upper 600s,” says Kyle Enright, president of lending at Achieve, a financial services company that offers loans and debt relief. “It’s possible to get a personal loan with a lower score, but the interest rate will be higher.”
No. 3 Budget for Success
Everyone should have at least a simple budget. If you don’t, take time to look at your spending and determine where the money goes now. Play around with a loan calculator to see how different interest rates and loan terms can affect a debt consolidation loan payment, and compare possible new payments to your current outgo.
If your payments are going up, where will the extra money come from? What possible cutbacks can you make? Keep in mind that in addition to making your debt consolidation payment, you’ll be clearing any new credit card balances in full each month. That’s the only way that you’ll break free from the revolving-debt trap.
If you can’t do this, debt consolidation is probably not the right solution for you.
No. 4 Prequalify for a Personal Loan
In addition to credit scores, Enright says, “Lenders also will look at debt-to-income ratio. Again, every lender is different. Some will want DTI to remain below 36%; some will have other criteria. Lenders usually also want to see that there is a source of stable income. If a borrower can’t qualify on their own (or can’t qualify for a favorable rate), they may consider a cosigner. A cosigner should have good credit history; the higher the credit score, the better.”
It’s smart to prequalify with several providers of different types — like credit unions, banks or other lending companies — to see which offers the best deal.
[Read: Best Debt Consolidation Loans.]
No. 5 Choose Your Loan
Look at your offers side by side. Compare the following:
— Loan amount. Is the approved loan amount enough to zero all of your credit cards? If not, you’ll want to pay off the ones with the highest interest rate first.
— Annual percentage rate. A loan APR incorporates the interest as well as origination fees and other charges. If there’s an origination fee, which is deducted from your loan proceeds, make sure that you’ll receive enough to pay off your cards.
— Monthly payment. Is it an amount that you can comfortably afford? You can lower your payment by extending your repayment term, but this increases your cost.
Once you find the lowest-costing loan that meets your needs, you can finalize your offer.
No. 6 Finalize Your Loan
When you prequalify for a loan, the lender has not committed to anything. Prequalification simply means that if the information on your application checks out, and your full credit report confirms what came up on the initial credit check, you will probably be approved — most likely under the terms disclosed in the preliminary offer you received.
Your lender may be able to confirm your banking, employment and income electronically, or it may ask you for items like recent pay stubs and bank statements. Once the lender has everything it needs, you can receive final approval and the funds can be released.
No. 7 Pay Off Your Credit Cards
Once your loan is authorized to fund, find out your exact credit card balances and pay off your accounts. “Consumers can use the proceeds to pay creditors directly or, in many cases, have the lender do it directly,” Enright says. “In Achieve’s case, when we pay creditors directly, we provide an interest-rate discount to the borrower on their loan.”
Can you keep your credit cards open after consolidating? “There’s no requirement when using a personal loan to pay off credit card debt for the borrower to close credit card accounts,” Enright says. “In fact, it is usually best not to close accounts, because the longer one retains a credit account, the more influential it can be in credit score calculations. However, you may want to consider doing so if there’d be too much temptation to overspend.”
No. 8 Make Your Personal Loan Payments
With a personal loan, you know exactly when your debt will be zeroed out, as long as you repay the loan as agreed. Consider setting up an auto pay to avoid missing or late payments, and to possibly receive a discount in your rate.
Alternatives to Personal Loans for Debt Consolidation
Consolidating debt with a personal loan is a great option for many, but it’s not the only solution.
— If personal loan payments would be too high and you have sufficient home equity, you might consolidate with a home equity loan or line of credit. The interest rate and payment would be lower, but the setup cost can be higher. The lifetime cost may also be higher (even at a lower rate) because you’d be extending repayment.
— Balance transfer credit cards can be appropriate for lower amounts. The zero-interest period can help you quickly clear large amounts. However, you may not be able to secure enough credit to pay off large amounts. You’ll also have to consider balance transfer fees.
— If your credit isn’t good enough to get a good debt consolidation loan, a debt management plan may help you reset. Credit counseling agencies can contact your creditors and negotiate lower rates and more affordable payments. However, you’ll have to close your credit cards.
— Debt settlement and bankruptcy are drastic solutions for people with overwhelming debt. The cost and consequences can be high, so consider these only if you can’t afford or qualify for less severe options.
Consolidating debt with a personal loan can be a smart move if you budget and stay disciplined.
“As long as you stick to your plan to repay the new personal loan on time — or even apply that extra discretionary income every month to pay it off sooner — you’ll better your financial position by consolidating with the personal loan,” says Terry Vergon. “Just don’t make the mistake of raising your standard of living before you pay the loan off completely. That would be the equivalent of throwing away a second chance at getting on top of your debt.”
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How to Consolidate Credit Card Debt, Step by Step originally appeared on usnews.com
