In a perfect world, no one would have to take out a loan to consolidate and pay off debt. In the real world, however, borrowing money is sometimes the only way to buy your way out.
This is mainly due to the high interest rates on credit cards. Because the average annual interest rate on credit cards will be 20.75 percent as of March 2024, consumers will have to pay significant amounts of money in interest. Almost none of their minimum payments go towards paying off their credit card balance – and that’s if they can stop using credit cards for purchases.
These challenges are why many people consolidate their credit card debt with a lower interest personal loan.
When a personal loan to pay off debt makes sense
Debt consolidation works by taking out a single loan to pay off multiple other debts. It’s true that consolidating debt with a personal loan means trading one type of debt for another. However, this strategy has advantages: you can qualify for a personal loan with affordable interest rates and fair terms.
You may qualify for a lower interest rate
To qualify for the best personal loan rates and terms, a FICO score of 800 or higher is typically required. But you can get competitive (i.e., near average) rates with a score of 670 or higher.
Regardless, personal loans have an average annual interest rate of 12.21 percent as of April 2024. That’s significantly lower than the current average annual interest rate of 20.75 percent on credit cards, meaning your interest savings could be significant.
You can combine your debts into one payment
If you combine multiple credit cards with their own payments and APRs, it can be difficult to create a debt repayment plan. You need to make sure you make and maximize your payments every month. By using a personal loan to pay off debt, you can eliminate multiple payments and go back to one payment per month – and hopefully with a much lower annual interest rate.
Consider using a debt payoff calculator to determine how much sooner you can pay off your debt with a lower interest rate.
Think about this simple example. Imagine you have $5,000 in debt on a credit card with a 17 percent APR and $7,000 in debt on a second credit card with a 21 percent APR. You can only bet $100 per credit card per month, for a total of $200 per month.
At that rate, you won’t even pay off all your interest, so you’ll never pay off the debt. If you can take out a personal loan against your total of $12,000 in credit card debt with a 10 percent APR, you can contribute your $200 each month and pay off more than your interest each month.
You can be assured of a lower monthly amount
If you’re struggling with the weight of your credit card debt and are still spending more on payments than you make each month, a personal loan with a lower APR and a fixed repayment schedule could be just what you need.
You may be able to get a lower monthly payment on your consolidated debt with a lower APR and a long enough repayment timeline. You’ll have to play with a debt consolidation calculator to know for sure.
You want to know exactly when you will be debt-free
A major problem with credit cards is that if you continue to use them for purchases, you may never pay off your debt. Personal loans, on the other hand, have a fixed interest rate, a fixed monthly payment, and a fixed repayment schedule that determines the exact date when you will pay off your debts for good.
If you’re tired of paying with credit cards but never making much progress, you may be better off consolidating your debt with a personal loan and then switching to cash or debit cards.
When a personal loan makes no sense
Signing up for a personal loan to pay off credit cards can be a money-saving venture, but that’s not always the case. Signs that you may want to try a different debt consolidation method will vary from person to person, but may include the following.
You have a small debt that you can pay off quickly
If you have a fairly manageable amount of debt that you can easily pay off within 12 to 21 months, you might consider signing up for a balance transfer credit card instead of a personal loan to pay off debt. With a 0 percent APR credit card, you can often get no interest on balance transfers for up to 21 months, although balance transfer fees will likely apply.
Although upfront balance transfer fees can cost up to 3 to 5 percent of your transferred balances, you can easily save hundreds of dollars or more in interest if you pay off your debt during your introductory offer. Some balance transfer credit cards also offer rewards and consumer benefits, so be sure to compare offers.
You continue to use the same spending pattern
Chances are if you have a large amount of credit card debt, you may not have the best spending habits. Consolidating your debts won’t stop you from getting into more debt if you just keep using the same spending habits.
You may want to reconsider your financial strategy before attempting to consolidate your debts so you can get a handle on your spending. Consider consulting a personal financial coach or learning more about different budgeting methods. Find out what works for you and create habits that will keep you out of debt in the long run before trying to address a symptom of your larger spending problem.
You urgently need help paying off your debts
Finally, there are times when you have so much debt that you feel powerless to pay it off without help. In these circumstances, you may be best served by working with a debt relief company or nonprofit Consumer Credit Counseling Services. You can also look into debt management plans or debt settlement plans, although the Federal Trade Commission (FTC) warns that not all third-party companies offering debt relief assistance are reputable.
If you have so much debt that it seems mathematically impossible for you to pay it off in your lifetime, you could also go bankrupt. It may be helpful to consult a CCCS advisor before making a decision. To weed out bad actors, the FTC says you should check with your attorney general and local consumer protection agency with any agency you’re considering.
Things you need to know to take out a personal loan
Personal loans are available through banks, credit unions and online lenders. Before you apply, research at least three lenders to ensure you get a loan with the best terms available to you. It is equally important to understand what lenders are looking for in applicants.
Lending guidelines vary by lender, but here are some general eligibility requirements to keep in mind:
- Creditworthiness: Your credit score sheds light on how you have handled your debt in the past and predicts the likelihood of default in the near future. The best loan terms are generally reserved for borrowers with good or excellent credit, as these pose the least risk to the lender. If your credit score is lower but you meet the lender’s minimum requirement, you can still get approved. That said, your borrowing costs will likely be much higher.
- Debt-income ratio: Lenders want to know if you have the resources to pay the monthly loan payment. So they generally require borrowers to have a steady source of employment and verifiable income – usually between $15,000 and $50,000 or more. Your DTI ratio, or the amount of your monthly income used to pay off debt, is just as important. It helps the lender determine if you can afford to take on more debt or if you are currently overburdened and not suitable for a personal loan.
You will also need to provide documents to the lender to verify your identity, address, employment and income. Be sure to contact the lenders you are considering to learn more about their guidelines and documentation requirements to avoid any surprises.
When you’re ready to apply, use each lender’s prequalification tool (if applicable). If there is a potential match, you can view loan offers, rates and monthly payments without affecting your credit score. If you decide to continue applying, a hard credit inquiry will be generated and your credit score may temporarily drop by a few points.
it comes down to
Imagine never having to pay a credit card bill again, or actually having the money to go on vacation or do something fun. Focusing on paying down debt can help you free up money every month, even if your main goal is simply to save some extra money.
A personal loan can make a lot of sense when consolidating debt, but make sure you consider all the options and tools available to you.
To get out of debt, you need to stop racking up more bills that you can’t pay. Whichever debt reduction option you choose, stop using credit cards and switch to cash or your debit card while you’re in debt payoff mode.
