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By Patty Moore at workingmotherlife.com. Patty is a blogger who writes about personal finance, careers, and family. You can follow Patty on Twitter @WorkMomLife.
Imagine you are a hard-pressed consumer with rather large credit card balances, and perhaps a huge student loan and/or mortgage layered on top. That can’t feel too pleasant. As you pay 15, or 20, or 29.99 percent on your credit card debt, your thoughts might wander to using a 0% balance transfer credit card. After all, balance transfer credit cards have become incredibly popular over the last decade. However, you may also want to consider paying down your credit card debt with a personal loan at a lower interest rate. And, like everything in life, there are pros and cons. Let’s explore.
A personal loan is an uncollateralized debt, meaning you can get one based on your creditworthiness rather than your possessions. That’s good and bad. The good part is that you won’t have to worry about a repo agent taking your car, your home, or your collection of rare coins. The bad part is that you would pay less for a loan collateralized by real property since this reduces the lender’s risk. Nonetheless, personal loans have become ubiquitous, thanks to non-bank lending institutions and peer-to-peer lenders.
- Reduce your interest expense: You might be paying more on your credit card balances than you would on a personal loan. A realistic example would be a combined credit card rate of 18 percent APY, compared to personal loan interest of 12 percent. All things being equal, you could use the loan to pay off your credit cards (which you should then stow away someplace inconvenient) and use the interest savings to pay down the personal loan.
- Consolidate: It’s a hassle to schedule payments each month on several credit cards. Miss one and you’re hit with a late charge. Furthermore, the combined minimum payments are probably higher than they would be if you owed the same amount on a single card. A personal loan gets rid of that hornet’s nest of credit cards, replacing it with one easy-to-schedule monthly payment.
- New way to motivate yourself: Psychologically, it might concentrate your efforts to get out of debt by having a single target – your personal loan – rather than several credit cards. With a personal loan, you face no complex decisions about which card to pay off first. Just concentrate on the personal loan by throwing every spare nickel at it.
- Not all personal loans are cheap: A personal loan looks like a great alternative when it charges only 12 percent. If your credit score garners you a loan offer at 36 percent, that isn’t so good. You probably shouldn’t consider a personal loan that isn’t at least 2 percentage points cheaper than your combined credit card rate. One solution is to borrow only enough to pay off credit cards that are more expensive than the loan, leaving the cheaper card debt intact.
- Bad habits die hard: What happens after you pay off the credit cards? If you continue to use them, then you’ve just made matters worse – now you have multiple debts, and the personal loan is not revolving, meaning you don’t get to pay some and then reborrow it. An article in com indicates that 70 percent of folks who consolidate credit card debt with a loan find themselves with the same or higher debt level within two years. Unless you can mend your ways and stay off the credit cards, your future will be clouded indeed. For this to work, you must “bite the bullet” and stop charging your purchases, even if that means your lifestyle suffers a temporary setback.
- Slower debt paydown: Even if you cut up your credit cards after paying them off, you might be tempted by the smaller monthly cash outflow required to pay off your personal loan. Will that extra cash burn a hole in your pocket and force you to spend it? If so, you’ll end up taking longer to pay off your personal loan. You should use some of the extra cash to build up an emergency fund, but in all cases, your monthly debt repayment should not decrease simply because you’ve traded your credit cards for a personal loan.
Nothing like a little math to clarify things. In this example, you owe $15,000 in credit card debt with an interest rate of 18 percent. You are contemplating a consolidating personal loan at 12 percent with a three-year term (assume no origination costs). You want to be out of debt at the end of three years, and you’ve promised yourself to cut up your credit cards as soon as you get the loan. Should you proceed?
- Credit card: To pay off your balance in three years (without creating any new credit card debt), you’ll have to spend $542.29 per month, and your total interest bill will be $4,522.29.
- Personal loan: A three-year personal loan will cost you $498.21/month and your total interest will be $2,935.73, a total savings of $1,586.56. Some of this savings will be eaten up by any fees associated with the loan. You can use the surplus to pay down your personal loan sooner, which will further reduce your interest expense.
Do the math and look in the mirror. If you think you’ve got the guts to curb your spending and the numbers work, go for it. Otherwise, you might do better not getting the loan, as you’ll save the origination fee and your debt will remain revolving. It’s your move!