Debtor Debbie is looking for the cheapest way to pay down her high-interest credit card debt. She has a good credit score, which means Debbie has options.
Two popular options include a 0% interest balance transfer credit card and an unsecured personal loan. Either will help Debtor Debbie become Debt-free Debbie, but there are a number of things she should consider make before reaching a decision.
Here are the 6 things Debbie, or any other borrower, should look at before deciding which type of financing to pursue.
Options to consider when consolidating credit card debt
- Interest rates
- Balance transfer fee
- Origination fee
- Introductory period length
- Fixed rates, payment schedule
- Credit score
This is the first, and probably most important, thing to look at when comparing credit cards and personal loans. With a 0% card offer, there’s an interest-free period upfront — which is better than any personal loan — but you’ll need to know what happens after the introductory period ends before making a judgment.
“Generally speaking the interest rate on a credit card is going to be higher than an interest rate on a personal loan, especially if you’ve got good credit,” says John Ulzheimer, a credit expert who formerly worked for credit companies FICO and Equifax.
The average personal loan rate is 10.94%, according to Bankrate’s most recent weekly national survey of banks and thrifts. With good credit, you can find a personal loan with an interest rate in the single digits. The average credit card rate is a variable 16.05%.
If you can’t pay the debt off before the end of the introductory period, you may be forced to pay interest retroactive to the day you opened the account, Ulzheimer says. If this happens to you, you almost certainly will have higher interest payments than you would have had with a personal loan.
“The best balance transfer card is still a really good option only inasmuch as you’re able to pay it off before the grace period expires,” Ulzheimer says.
CARD SEARCH: Compare balance transfer credit cards now.
Balance transfer fee
Many balance transfer offers include a one-time fee, which can add up to about 3% to 5% of the total you want to transfer, says Thomas Nitzsche, a certified credit counselor and spokesman for ClearPoint Credit Counseling Solutions based in Atlanta.
For example, if you want to transfer $5,000 to a new card that charges 0% interest for 12 months, you might be hit with a fee of $150 to $250.
That’s still cheaper than a 12-month personal loan with an 11% interest rate. Go this route and you’ll pay $303 in interest.
“At the end of the day, the name of the game is to pay the least amount of interest possible,” says Steve Repak, a North Carolina-based CFP professional and author of “6 Week Money Challenge.”
Use a debt consolidation calculator to see which option is cheaper for you.
If you look to an online lender for a personal loan, know that many of them a charge loan origination fee, a one-time charge that is taken out of the total amount you receive. Banks and credit unions typically do not charge an origination fee on personal loans.
These fees can be as high as 6% of the loan. In other words, if you asked for a $5,000 loan to consolidate credit card debt, you might receive $4,700, with a $300 origination fee deducted from your balance.
This fee is typically included in the annual percentage rate, which allows you to make a fair comparison between loans.
Introductory period length
How long the 0% interest period lasts is also a key consideration. If you have $5,000 in debt to pay off and you receive a 6-month grace period, will that be enough time for you to pay off the balance?
If it’s not, you may want to consider a personal loan.
Here are the key questions Repak says you should ask yourself:
- What’s the total amount of debt?
- What’s the interest rate?
- What is the payment that you are able to afford?
In the above example, you would have to pay $833 a month to pay off a $5,000 debt in 6 months at 0% interest.
Fixed rates, payment schedule
Ulzheimer says he favors personal loans in this situation because the interest rate never changes and the loan has a fixed payoff date.
“It helps with budgeting and also it’s predictable, where the credit card may be great coming out of the gate, but if you’re not managing it absolutely perfectly, then you might find yourself in the long run actually paying more for a longer period of time than had you chosen the personal loan upfront,” he says.
Repak says he favors a balance transfer because it’s more flexible than a personal loan.
“What if you lose your job or what if something comes up, some type of financial emergency where you can’t make that $500 payment?” Repak says. “A 0% transfer might give you some flexibility even though it might cost you more. With a fixed payment, you’re kind of stuck with that.”
CARD SEARCH: Find a low-rate credit card today.
Because of the negative emphasis credit scoring models place on revolving debt, taking out a personal loan could improve your credit score, while taking out a balance transfer card could harm it, Ulzheimer says.
That’s because opening up a new card and transferring all your credit card balances to it could push the utilization ratio on that card to near 100%. That could hurt your score.
Taking out a personal loan to consolidate debt could lower your utilization rate to 0%. That could help your score.
“You didn’t really get out of debt, you just converted the debt,” Ulzheimer says, but that’s not really how credit scoring models see it.
Taking out a credit card could also harm your score if you don’t pay the debt down, but continue to transfer it from one card to another, Nitzsche says.
“If you’re looking at doing that, it’s kind of an early stage red flag that something might be wrong and that you need to really examine that, especially if it’s a pattern,” he says. “If you’ve done it habitually then definitely there’s an underlying issue there that needs to be addressed.”
RATE SEARCH: Ready to be debt-free? Find a personal loan today.