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It’s no secret that Americans have a complicated relationship with debt. Total revolving debt — which includes credit cards and other lines of credit — is more than $1 trillion, and has been creeping up ever since the financial crisis. As of April 2018, the average household that had credit card debt owed $9,333.
If you’re juggling a lot of credit card bills and want to try to lower your interest rate, you may find that a personal loan can help you by allowing you to consolidate your debt. Debt consolidation is where you take out a personal loan to pay off your credit card bills, usually at a lower interest rate.
What is a personal loan?
With a personal loan, once you’re approved, you receive a lump sum for the entire amount of the loan. You’re then required to pay back the loan and its interest over a set period of time. Because they have fixed interest rates, personal loans may make it easier to budget every month than dealing with multiple varying credit card amounts.
A personal loan can be secured by collateral — for example, a car — or unsecured. Unsecured loans are more popular, but may be harder to qualify for. With either type of personal loan, the lender will look at your credit record, credit scores, income and perhaps employment to approve you.
Taking out a personal loan is a big decision, so review your current and future debts carefully while weighing the pros and cons of a personal loan to determine whether one will improve — or worsen — your current financial situation.
Advantages of using a personal loan to pay off debt
Here are a few reasons why applying for a personal loan may make sense.
1. Lower interest rates
If you have a good credit score, you may be able to find a personal loan with a much improved annual percentage rate, or APR. You’ll find average interest rates on personal loans in 2019 are 10-28%, depending on your credit score.
Let’s say you have $5,000 in outstanding credit card debt. You plan to pay that debt over the course of 12 months with an interest rate of 15%. Over that year, you’ll pay $346 in interest. A personal loan paid down over the same time period with an interest rate of 10%, however, will only cost you $230 in interest.
You can figure out your own savings using our credit card payoff calculator.
2. Lower monthly payments
A lower interest rate also can reduce your monthly payment. Using the same example as above, a full monthly payment on $5,000 with a 15% interest rate is $448, while you’d owe $437 with a 10% interest rate. While that’s not a significant difference when you’re talking about a $5,000 debt, the more you owe, the more you’ll save by lowering your interest rate. And reducing payments — even a little — can give you some breathing room each month.
3. Consolidate debt into one payment
When you consolidate debt, you replace multiple credit card accounts with one loan. That means fewer bills each month, fewer accounts you’ll have to remember to log into, and a greater chance of paying your balance on time.
Disadvantages of using a personal loan to pay off debt
Personal loans don’t always make sense, however. Look carefully at your situation before applying for one.
1. Higher interest rates
As discussed above, personal loans can have lower interest rates than the credit cards you’re trying to pay off. That said, the interest rate may not always be as low as some low-interest credit cards. The interest rate for the personal loan you’ll get is largely determined by your credit history. Average interest rates for a personal loan range from 10% for those with excellent credit to 28% for those with poor credit scores.
If you have good credit, you may be able to find a balance transfer credit card with a 0% interest rate for a period of up to 21 months, which could work better than a personal loan.
2. Additional fees
Sure, shopping for a competitive interest rate is critical when finding a personal loan, but what about those “extras” that can add up quickly? A loan origination fee, for instance, is a charge for drafting the loan paperwork, and can range from 1-6% of the total loan. Ask for a rundown of any other fees, including monthly administrative charges, late repayment fees and prepayment charges.
3. Increased monthly payments
Lower payments on personal loans aren’t a given. Since the average personal loan has a repayment period of one to seven years, you may end up paying a much higher monthly payment than you would on your credit card if you took longer to pay off the card. (Your credit card company will charge you interest in the process of a longer repayment term, of course.) If you don’t have extra wiggle room in your monthly budget, a personal loan may not be your best bet.
How to find a personal loan
The first step to finding a personal loan is doing your homework. Shop around for lenders, such as banks, online lenders and credit unions with competitive rates. While traditional lenders may offer you a competitive rate, online lenders actually may provide more flexibility on loan terms. Check with your current bank or credit union, as they may be more willing to extend a loan with a competitive rate based on your history with them.
A personal loan lender may take into account such factors as:
- Your credit score
- Your debt-to-income ratio (i.e., your ability to pay back your loan each month based on how much you make)
- Your income
- Your work or education history
What to look for when applying for a personal loan
You’ll want to take into consideration:
- Loan length: While a loan with a longer repayment schedule can save you money in the short run due to smaller monthly payments, the longer you draw out a personal loan, the more you’ll end up paying in interest. Carefully consider your monthly cash flow and your ability to make timely payments when discussing loan terms.
- Interest rates: Your interest rate significantly affects your debt’s overall cost. Sit down with your lender or use an interest-rate calculator to determine how much interest you’ll pay over the life of your loan.
- Other charges: Ask your lender for a full list of fees associated with the personal loan, and factor them into your personal loan total.
Other debt-payoff options
Depending on your financial situation, you may find other, more suitable methods to paying off your debt.
- Balance transfer credit cards: As mentioned above, this type of credit card allows you to pay off balances on existing debt by transferring the debt to a single credit card. If you have good credit, you may be able to get a card that charges no interest for more than a year. If you can pay off your debt within that time, a balance transfer card may be a better deal for you than a personal loan.
- Peer-to-peer loan: This newer form of lending involves borrowing from individuals who invest in loans online, with flexible terms and low interest rates. You may find better interest rates with a peer-to-peer loan than with a personal loan.
- Home equity loan (HEL) or home equity line of credit (HELOC): Both HELs and HELOCs tap into your home equity for collateral. That means they may have lower interest rates than a personal loan. But if you use one for debt consolidation, you’re trading unsecured debt for secured debt. If you default on your payments, you could lose your house. For this reason, experts don’t generally recommend using home equity products for debt consolidation.
Breaking the debt cycle
Once you’ve found a suitable lender and loan, the real work begins. One trap to beware of with debt consolidation is that you could go back and rack up more debt on your old credit cards. That will leave you worse off than when you started. Here are a couple of things you can do to make sure that doesn’t happen:
- Change your spending habits: Stick to a budget and track every dollar you spend so you understand where your money goes. Use financial apps like YNAB and Mint to help you track your spending and adhere to your budget.
- Work with your lender or a financial advisor: Create a plan for repaying the loan. Set up automatic payments or calendar reminders to ensure you’re committed to paying down your loan in a timely fashion.
Using a personal loan for debt consolidation may allow you to pay off your debt once and for all. When shopping for any loan, make sure you weigh all your options to ensure you’re making the best decision for your financial present and future.