Taking out a personal loan to consolidate or pay off mounting debts is not exactly a new development.
However, according to a recent Lending Tree study, it has grown to be the overwhelming reason Americans access personal loans these days. In fact, the study revealed that managing existing debt represented 61% of personal loan requests in 2018. The next closest category was home repairs, at a meager 7.7%. That’s a significant gap.
What’s more, consumers seeking a personal loan to pay off debt requested the highest origination amounts: $14,107 on average for credit card refinancing, and $12,670 for debt consolidation.
But is this growing penchant for using personal loans to tackle debt the wisest approach? Is it smart to fight debt with more debt? Here’s what the experts had to say.
Lower Interest Rate
One of the most obvious benefits of shifting credit card debt to a personal loan is the opportunity to access a lower interest rate, which can ultimately reduce your overall costs. That can mean more money in your pocket, or help you put more money toward the principal balance and less toward interest.
This type of savings is typically most significant for those with a good credit score, who are thus are able to secure the most favorable interest rates.
“If your credit card debt was costing you 25.99% per year while a personal loan costs 12.99%, congratulations, you just saved yourself a hefty amount of interest,” says Riley Adams, a CPA and creator of the site Young and the Invested. “The lower interest payments should help with repaying the loan, because you’ll have more room in your budget to manage the payments.”
But just because a personal loan might lower your monthly payments, doesn’t mean you shouldn’t try to pay off the debt as aggressively as possible. In fact, Adams suggests taking whatever money you saved each month by shifting the debt from credit cards to a personal loan and continuing to put it all toward the loan payments, in order to reach financial freedom sooner.
- Read more: 11 Ways to Get Out of Debt Faster
Simplifying Monthly Payments
Combining various debts into a single monthly payment is another good reason to consider a personal loan, particularly if you’re the type who gets overwhelmed by a flurry of bills from different companies.
“Consolidating a variety of growing debts into one straightforward personal loan can make it considerably easier to keep on top of your payments,” said Sean Messier, a credit industry analyst for Credit Card Insider. “Dealing with multiple bills can be stressful, particularly if you’re the forgetful type.”
Not only will having just one bill make things simpler, many lenders will allow you to set up autopay, to further ensure you avoid missed payments, said Messier.
Improved Credit Score
Yet another benefit of taking the personal loan route to repaying multiple debts is that it can often improve your credit score.
This is true for multiple reasons. To begin with, credit scoring models view installment loans differently from revolving credit card balances. Paying off credit cards balances will lower your credit card utilization ratio, which, when too high, can significantly reduce your overall score.
And by having just one lower monthly payment, you’re less likely to make a late payment or miss one altogether. A consistent on-time payment history is the biggest factor in your credit score.
“A single, low-interest monthly bill will likely make it easier to build a habit of on-time payments, which can help repair any damage dealt through missed due dates and other debt-management missteps,” said Messier.
A Personal Loan Isn’t Right for Everyone
As Adams mentioned, using a personal loan to pay off debts makes the most sense for those who have a solid credit score. However, if you have a low credit score and thus can’t secure a favorable interest rate, this approach may not save any money at all.
The key is to sit down and crunch the numbers, determining whether a personal loan makes sense for your situation before making any changes.
“A personal loan may make your debt unaffordable,” explained Adams. “This is especially true if you end up with an interest rate on a loan that is close to or above your current debt rate.”
What’s more, some lenders may charge an origination fee to process your loan, said Nishank Khanna of Clarify Capital. When factoring in this added cost, there may not be as much savings as you’d hoped.
“Depending on how much debt you currently have, it might not be worth paying the fee to pay off other debt,” explained Khanna. “You need to calculate the precise amount you would be saving by factoring in all costs associated with getting a personal loan.”
Using personal loans to free up credit cards can also be a dangerous prospect for those who aren’t good at resisting temptation and will likely to start racking up credit card debt once again. It’s a scenario that mortgage banker Corey Vandenberg, of Platinum Home Mortgage, has seen time and time again.
“A customer will go right back out and opens more credit cards and gets in the same mess again, maybe worse since now they have a loan debt and credit cards,” explained Vandenberg. “This can even happen if the lender forces you to close the credit cards, as your score will likely improve quickly and make getting more cards easy enough.”
The key is to be committed to changing your behavior and not repeating the cycle of getting more credit cards and accruing more debt. Revolving credit, added Vandenberg, was made to use short term and pay off in the short term.
“Use credit cards sparingly from now on, only what you can afford to pay off in the next three months, and your score will soar,” said Vandenberg.
- Read more: When You Should – and Shouldn’t – Use a Personal Loan
How to Secure the Best Deal on a Personal Loan
If you’re considering a personal loan to pay off debt, there’s a variety of steps you can take to secure the best possible deal.
Khanna, of Clarify Capital says improving your credit score should be the first course of action, as that all-important score will determine the interest rate you qualify for on a loan. While it takes time to dramatically improve your score, there are some ways to raise your credit score modestly in just a few weeks.
Next, find out what a good deal on a personal loan is, says Mike Sullivan, a personal finance consultant with Take Charge America, a national nonprofit credit counseling and debt management agency.
“There are websites that show rates advertised by multiple lenders,” said Sullivan, who suggests doing your research to identify the going rate.
After that, try applying to the lender with the best advertised rate to see if you qualify, suggests Sullivan. “Many offers are for people with very high credit scores only,” he explained. “Your best deal may not be the best deal advertised.”
Once you have an idea of the rate you will qualify for, Sullivan suggests visiting your local bank or credit union with your newfound information in hand.
“Follow-up with the bank you’re familiar with, your local bank and say, ‘Look, I found online that I can get a 7% or 8% loan, can you match that or beat it?’” explained Sullivan.
Finally, don’t be afraid to haggle, particularly with your local bank. Financial institutions have been known to give a break to customers to keep them loyal, said Sullivan.
The post Fighting Debt With Debt: America’s Penchant for Personal Loans appeared first on The Simple Dollar.