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Using a Personal Loan to Pay Off Credit Cards

Understand the key tradeoffs when you pay off credit card debt with a personal loan.

Trading one type of debt for another

Using a personal loan to pay off credit cards is just one option you can use for do-it-yourself debt consolidation. It allows you to roll all your high interest rate credit card balances into one payment at a low rate. However, this only works as an effective debt solution if you meet three key criteria.

#1: Do you have a high enough credit score to qualify for a good rate?

This is the number one factor in determining how effective you can be with this debt solution. In order to qualify for the interest rate you need on the consolidation loan, you need a high credit score. Otherwise, you either won’t get approved for the loan or the rate will be too high to provide the benefit you need.

You want the lowest rate possible, so the higher your credit score the more effective this solution will be. At most, you want an interest rate that’s less than 10 percent. Anything in the 4-7% range is best. This also means that as the Federal Reserve raises their benchmark rate, consolidation loans become less effective. The ideal time to get into a consolidation loan is when rates are low. However, even as rates increase you should still be able to qualify at a good credit with a good credit score.

So, if you don’t have good credit, you may need to look elsewhere to find debt relief.

Pop Quiz

How much money would you save if you consolidate $10,000 in credit card debt at 15% APR with a 60-month personal loan at 5% APR?

a) Almost $5,000

b) Almost $10,000

c) Almost $15,000

d) Almost $20,000

Reveal Answer

On a minimum payment schedule, you’d pay $15,851 in total interest charges over 424 months; the monthly payments would start at around $200 per month and decrease over time. With the loan, you’d make fixed payments of $188.71 for 60 months, for total interest charges of just $1,322.74

c) Almost $15,000

Return to question

#2: Can you afford the monthly payments with a term of 5 years or less?

The longer it takes to pay off your debt, the more months the lender has to apply interest charges.  In other words, the longer the term of your loan, the higher the total cost for you. In general, debt elimination experts say a credit card debt repayment strategy should take five years or less.

However, a shorter term means higher monthly payments. The payments on a 5-year loan (60 payments) are higher than a 7-year loan (84 payments). Review your budget carefully to see if you can afford the payments with a term of less than five years.

Any more than that and you increase your total cost too much – it’s just not worth your effort to consolidate. What’s more, a repayment plan that takes longer than five years will be exhausting. Trying to avoid using your credit cards for that long while you eliminate the debt will be tough. And if you go back to charging before you pay the loan off, you can wind up in a worse situation. Which leads us to…

#3: Do you have the discipline to avoid using your cards after you consolidate?

One of the most common pitfalls with debt consolidation is that you start spending again before you eliminate your debt. When your credit card balances are high, it often keeps you from making new charges. You don’t want to add to your debt.

However, when you use a personal loan to consolidate credit cards, it gives you a false impression of financial stability. Your cards all have zero balances, so it can be tempting to start making charges again. Meanwhile, you still have the loan to pay off. While you may be able to afford the loan payments without your credit card bills, having both could be problematic.

This is the number one reason that people end up re-consolidating. They start charging again too early and their bills pile up to go beyond what they can afford to pay. You have to avoid this to use a personal consolidation loan effectively.

It’s important to note that one relief option – a debt management program – prevents this situation. Once you enroll, your creditors freeze your accounts and you can’t apply for new accounts until you finish the program. This helps you walk the path to eliminate your debt, even if it’s tough to give up your cards at first.

So, without this safeguard, it’s up to you to give up card usage until you have control of your debt.

Paying off credit card debt with a personal loan vs. a home equity loan

A personal loan is not the only lending option available for credit card debt relief. People may tell you to just use a home equity loan. But in most cases, those people are wrong. Here’s why…

A home equity loan increases your risk

A home equity loan is a secured loan. You use your home as collateral to get the funds you need. Basically, you cash out equity in your home that you can use for whatever you need. In this case, you cash out equity to pay off credit cards.

The problem with that is that you effectively convert unsecured debt into secured debt. Credit cards are usually unsecured. That means there’s no collateral in place to protect the lender in case of default. As much as debt collectors may threaten, they can’t take your property without a court order. They have to sue you in civil court to get their money back.

On the other hand, if you fall behind on your home equity loan payments, the lender will start a foreclosure action. If you don’t catch up, you can lose your home. The increased risk of this is usually not worth it just to pay off your credit cards. Even if you can afford the payments now, what happens if you lose your job?

This makes an unsecured personal loan a much better option. Unsecured debt stays unsecured and you home is never at risk.

Fact:Prior to the crash and just following it from 1999-2010, 26% of HELOCs (home equity lines of credit) were used to pay off credit cards

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