8 Pros and Cons of Using Personal Loans to Consolidate Credit Card Debt
Money Girl explains the pros and cons of using personal loans to consolidate or pay off credit card debt. You’ll find out the best places to apply for a personal loan and how consolidating affects your credit.
About one half of all American households are carrying credit card debt, with an average balance above $15,000. If you’re one of them, you’re probably paying way too much interest for your debt than you should.
In this episode, I’ll tell you the pros and cons of using personal loans to consolidate or pay off credit card debt. You’ll find out the best places to apply for a personal loan and how consolidating affects your credit score.
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What Is a Personal Loan?
A personal loan is money you borrow to pay for just about anything, such as your wedding, a dream vacation, a new computer, medical bills, or to consolidate other debts.
There are two main types of personal loans: secured and unsecured.
- With a secured personal loan, you’re required to pledge collateral, such as a car or house, to back up the loan in case you don’t make payments.
- With an unsecured personal loan, which is much more common, you don’t need to put up any collateral. Unsecured loans are also known as consumer or signature loans.
See also: 5 Ways to Get a Loan With Bad Credit
How to Get a Personal Loan
You can get a personal loan at most banks, credit unions, and a variety of online lending companies. The amount you can borrow depends on the lender, your credit, and your income.
Personal unsecured loan amounts usually range from $2,000 to $35,000 and have a fixed interest rate. If you want to borrow more, you typically have to apply for a secured loan.
Personal loans come with a choice of repayment terms that may range from 3 to 10 years. If you want to pay off your personal loan ahead of schedule, most don’t charge you a prepayment penalty.
However, most personal loans come with an origination fee that could range from 1% to 10% of the loan amount. This is a one-time fee deducted from your loan proceeds.
You may see an initial interest rate when you apply, but a higher rate when you’re quoted. This is because the fee must be included in the annual percentage rate (APR) for the loan you choose.
That means one lender that seems to have a lower APR may actually be more expensive if they charge a higher origination fee than another lender. So, do your homework by shopping and comparing interest rates with multiple lenders.
Free Resource: Online Loan Comparison Chart (PDF download)
What Happens When You’re Approved for a Personal Loan
Paying down your principal balance sooner means that you’ll pay less interest over the term of the loan.
When you’re approved for a personal loan, you’ll receive a check or a direct deposit into your bank account within days. Then you make regular monthly payments, just like you do with other types of installment loans, like a car loan or home mortgage.
For each loan payment you make, a portion goes toward the principal amount you borrowed and toward the interest owed on the outstanding balance.
If you can pay more than your monthly payment, make sure the lender knows to apply it toward your principal balance. Otherwise, they may hold it in an escrow account or put it toward future interest payments, instead of using it to decrease the amount you owe.
This is important because paying down your principal balance sooner means that you’ll pay less interest over the term of the loan.
Let’s say you get a personal loan of $25,000 with a 7% APR for 3 years. Your monthly payment would be $772 and you’d pay a total of approximately $2,800 in interest over the life of the loan. If you paid an additional $100 each month you’d pay off the loan 5 months earlier and save over $350 in interest.
See also: Pay Lower Interest Rates on Debt and Save Money
Pros of Using Personal Loans to Consolidate Credit Card Debt
Here are 5 main pros or benefits of using a personal loan to consolidate your credit card debt:
Pro #1: Paying a Lower Interest Rate
Cutting your interest expense is the primary reason to consolidate debt in the first place. Let’s say you have a $10,000 balance on 2 credit cards. If one charges 18% and one charges 10%, paying them off with a loan that charges 9% will save you money.
High interest rates are one of the reasons many people stay in debt longer than they should. It’s wise to reduce the cost of your debt so you can eliminate it faster.
Pro #2: Getting Fixed Terms
Personal loans are a type of installment loan, which means you have a specific interest rate and term, such as paying 9% for 3 years with monthly payments of $750.
If you’ve gotten out of control with credit card spending, having the discipline of a set term might help you pay off debt faster. Of course, be sure that the repayment term is affordable. Never commit to a payment schedule that you can’t meet.
In general, the shorter your term, the higher your monthly payment. Having a longer term cuts your monthly payment—problem is, it also increases the amount of interest you’ll pay over the life of the loan.
So, I recommend choosing the shortest repayment period that you can reasonably afford.
Free Resource: Laura’s Recommended Tools—use them to earn more, save more, and accomplish more with your money!
Pro #3: Having One Payment
Consolidating multiple credit cards with a personal loan can simplify your financial life. You’ll only have to keep track of one bill due date instead of several.
You can focus all your time and attention on making that single payment, counting down the months until your debt is completely wiped out.
Pro #4: Reducing Your Monthly Payment
Using a personal loan to consolidate debt can lower your total monthly payments.
For example, if the total of your minimum credit card payments is $500 and your new loan payment is $400, you have an additional $100 each month to pay down your loan’s principal balance even faster.
But this will depend on how you structure your loan. As I mentioned, the shorter the term, the higher your monthly payments will be.
Pro #5: Building credit
Having an additional loan on your credit report will help you build credit, if you make payments on time. Plus, paying off or reducing your credit card balances can boost your credit by lowering your utilization ratio.
To learn more about this topic, read or listen to Credit Utilization—What It Means For Your Credit Score.
Free Resource: Credit Score Survival Kit—a video tutorial to build credit fast
Cons of Using Personal Loans to Consolidate Credit Card Debt
Here are three main cons about using a personal loan to consolidate your credit card debt:
Con #1: Continuing to Use Credit Cards
Doing a consolidation should be part of a bigger plan to pay off debt. If you use a personal loan to pay off your credit cards, but then rack them back up, you’ve gotten deeper into debt. So, you must be committed to never carrying credit card balances again.
Those clean cards can be awfully tempting! Make sure you get a fresh start by only making charges that you can pay off in full each month.
If you continue to accumulate debt, it doesn’t matter how many times you move it around to lower interest options, it will continue to be a drag on your finances and keep you from building wealth.
So know your own capabilities, financial habits, and be honest with yourself. If you don’t have the discipline to use your credit cards wisely after a consolidation, lock them up and only spend cash.
See also: 6 Risky Situations When You Should Avoid Using a Debit Card
Con #2: Having Higher Monthly Payments
While monthly payments for a personal loan can be lower than the total of all your minimum credit card payments, they can also be higher. As I previously mentioned, the payment amount depends on how much you borrow, your interest rate, and the loan length.
Unlike a credit card where you can make a minimum payment, with a personal loan you’re required to make the full payment every month. If you pay late, you can destroy your credit.
Con #3: Saving Too Little
If your credit card debt is relatively small or you can pay it off within the next 12 months, using a personal loan to consolidate may not save you enough to be worthwhile.
When you know that you can pay off a credit card in the near future, but still want to cut the interest, consider using a zero interest balance transfer credit card. The promotional period on these cards can range from 6 to 24 months, giving you a nice break from interest charges.
However, if you don’t pay off the entire balance before the promotion expires you can end up paying more interest than if you hadn’t made the transfer.
See also: When to Use a Balance Transfer Credit Card
Where to Get a Personal Loan to Consolidate Credit Card Debt?
To sum up, a personal loan is a smart financial tool to use if it’s the least expensive option for you to consolidate debt.
While it may seem odd to use new debt to get out of old debt, it all comes down to the interest rate. By using a personal loan the right way you can reduce your interest payments and get out of debt the fastest way possible.
Having less debt will free up more of your money so you can achieve positive financial goals like building your emergency fund, investing in real estate, or saving for retirement.
Here are some of the best places to shop for your personal loan online:
To see my review of 10 online lenders, including loan APR, maximum loan amounts, and type of loan offered (such as personal, student, auto, home, or business) download the free Online Loan Comparison Chart (PDF download).
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
