Millions of Americans are awash in debt. If you are among them, you might be tempted to take out a personal loan to consolidate your credit card debt. Doing so can make sense, but only in certain situations.
Weighing the pros and cons of various payoff methods can help you choose the best strategy for your financial situation.
What Is a Personal Loan?
A personal loan is a lump sum of money borrowed from a bank, a credit union or an online lender and paid back in installments, with interest, over a fixed period of time. You can generally use funds from a personal loan for whatever purpose you deem fit. Common uses might include consolidating debt, paying medical bills and making a large purchase.
Typically, you can borrow anywhere from a few hundred dollars to thousands of dollars. Your interest rate can be either fixed or adjustable, but most personal loans have fixed rates. Personal loans may also come with fees that can add to the expense of borrowing.
When you apply for a personal loan, lenders will consider many factors, including your:
Should You Use a Personal Loan to Consolidate Credit Card Debt?
Using a personal loan to consolidate credit card debt can make sense when two things are true, says Todd Christensen, education manager at Money Fit by DRS, a nonprofit credit and debt counseling organization. First, you have addressed the reason for your debt. Second, the loan comes with a lower interest rate than your credit cards.
Confronting and correcting the cause of your debt is especially crucial, Christensen says. If you do not change habits and circumstances that led to your debt, you could end up back in the red, he says.
“The borrower risks doubling their debt balances by running their credit card balances back up after transferring the original balance to the new loan,” Christensen says.
Pros and Cons of Using Personal Loans for Debt Consolidation
- You could reduce your interest rate. If you can qualify for a low-interest personal loan, you could save money as you pay off your debt.
- You could get out of debt faster. The money you save on interest might help you get out of debt more quickly, says Alli Wetzeler, a credit counselor at Consumer Credit of Des Moines. “Especially with credit cards, if you have a really high interest rate and you are paying just the minimum every month, it can take many years to pay them down,” Wetzeler says.
- You could boost your credit score. Paying off credit card balances lowers your credit utilization ratio, an important factor in your credit score. “If you have several credit cards that have high utilization, this can be hard on your credit score,” Wetzeler says. “Paying those off can help bring that percentage down, and your score can go up.”
- You can streamline your monthly payments. Consolidating eliminates the need to track multiple payment due dates, amounts and interest rates. You combine your debts into one payment, usually at a fixed interest rate that won’t change over the life of the loan.
- You may not qualify for a low rate. This is possible if you are deep in debt and have other blemishes on your credit report. “If you have a lower credit score, then your personal loan rates may be really high,” Wetzeler says.
- You could end up worse off than when you started. Falling behind on loan payments could mean late fees, missed payments reported to the credit bureaus and hits to your credit score.
- You haven’t solved the root problem. Taking out a loan to pay off credit cards will leave your cards with a zero balance, and you might be tempted to use them. But that can dig an even deeper hole. “It doesn’t address the original problem,” Wetzeler says. “This could result in an even more difficult situation.”
Alternatives to Personal Loans for Consolidating Debt
Taking out a personal loan is not the only method of tackling debt. Several alternatives to personal loans include:
Kevin Lum, a certified financial planner and founder of Foundry Financial in Los Angeles, says a couple of his clients have used this option.
“You typically have a fee of 4% to 5% upfront, but then you have 18 months to pay off the debt without any interest,” Lum says.
A balance transfer credit card only makes sense if your spending is under control, Christensen says. You will also need good or excellent credit, a score of at least 670 on the FICO scale, to qualify for this type of card.
“Moving your debt from one account to another just because of lower interest rates is not a debt elimination plan,” he says. “It’s a debt shuffle.”
Because a HELOC is secured by your home as collateral, it represents a smaller risk to lenders than other types of loans. That means a lender will typically let you borrow at a much lower interest rate than you might find on a credit card, which is often unsecured.
But using a HELOC to pay off credit card debt also involves serious risks. Defaulting on a HELOC can put your home in jeopardy, and some people who move their debt to a HELOC may see a newly cleared credit card as an invitation to begin running up charges.
Debt snowball or debt avalanche payoff strategy. In some cases, your best option is to forget about taking out a loan and instead devote more energy to paying off your debt. “If the borrower can’t get a loan with an APR lower than their current credit cards, it is likely better to pay down the balances on the current accounts rather than transferring them,” Christensen says.
When paying off debts, you can generally use one of two approaches:
- The debt snowball method, in which you pay off your smallest debt first while you make minimum payments on the rest of your debts. Put all extra cash toward the smallest debt until it is paid off, and then move to the next-smallest debt, repeating until all of your debts are paid off.
- The debt avalanche method, in which you make payments on your highest-interest debt, even if paying it off takes a long time. You continue paying off balances in order from highest to lowest annual percentage rate.
Both methods have pros and cons. Some people prefer the snowball method because you get a quick win that creates momentum to keep paying down your debts. Others prefer to prioritize their most expensive debts because they save the most money in the long run, even though payoff can seem frustratingly long.
Paying down your debt directly can be one of the most effective ways to get out of the red. Nadine Marie Burns, a certified financial planner and president of A New Path Financial in Ann Arbor, Michigan, says she took a second job to pay off the debt she owed after obtaining an MBA.
“I worked all day, then taught classes at night as an adjunct,” Burns says. “Those funds went directly to debt to help me pay it off faster. The time I spent working also was time I was not spending more money.”
Negotiating a lower interest rate. Check whether your credit card issuer will agree to lower your rate, Christensen says. “A lower interest rate typically means lower monthly payments,” he says.
Credit card companies are more likely to drop your interest rate if you have a history of making payments on time for at least a year, Christensen adds. “It’s less likely to happen,” he says, if you look like a high risk to the issuer – say, you maxed out your card.
Enrolling in a hardship program, such as forbearance. If you are facing a temporary financial hardship and can’t make your credit card payment, ask for details about your credit card company’s hardship program, Christensen says. Examples of hardships might include a layoff or pay reduction, a serious injury or illness, a family emergency, or a natural disaster.
“Each credit card company will have its own hardship program,” Christensen says. “Some will offer lower interest rates, while others might offer a month without a payment due.”
Some hardship programs last one month, and others might last up to six months, he says.
Debt management plan. If taking matters into your own hands is not working out or you simply want expert help, a nonprofit credit counselor can establish a debt management plan that rolls all of your bills into a single payment. A debt management plan can save you money by cutting your interest rates, which also helps you pay off your debt faster.
Consumers in debt management plans may see their credit card APRs “decrease to somewhere in the single-digit territory,” Christensen says.
A debt management plan can be a good option for many people, Wetzeler adds. “The credit cards close, so the debts don’t continue to rise,” she says.
Will Getting a Personal Loan for Credit Card Debt Hurt Your Credit Score?
A personal loan could help or hurt your credit score depending on your credit profile and how you manage the loan. It could improve your score by:
- Enhancing your credit mix. A personal loan could round out your credit mix if you have mostly revolving credit accounts.
- Building a positive payment history. You will need to pay in full and on time every month for your score to benefit.
- Paying off your credit card balances. Clearing your card balances will lower your credit utilization ratio, a key component of your credit score.
Taking out a loan to pay off debt could hurt your score by:
- Creating a hard inquiry on your credit report when you apply. A hard inquiry can stay on your credit report for up to two years, but the effect may start to fade after a few months.
- Tempting you to take on more credit card debt. If you use the loan to pay off your cards and then start charging up the cards again, you could end up worse off financially.