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.
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.
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.
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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.