How a personal loan can be a useful debt consolidation strategy
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Paying off credit card debt is more important than ever these days, since the average credit card rate is a record-high 19.95 percent. If you have the average credit card balance ($5,474, according to TransUnion) and you only make minimum payments at 19.95 percent, you’ll be in debt for a staggering 202 months and will owe a total of $7,678 in interest. Those minimum payments start at $146 per month and decline along with the balance.
We certainly want you to pay way more than the minimum — pay it all if you can. But what if you’re among the 46 percent of credit cardholders who carry debt from month to month?
A personal loan could help lower your bill, since personal loan rates go as low as about 6.5 percent. You could receive a lump sum from a personal loan and use it to pay off your credit cards right away. Then you might have up to seven years to pay back the personal loan at a much more favorable rate than your credit card would have charged.
Going back to that $5,474 average credit card balance: If you borrowed that much via a personal loan at 6.5 percent over seven years, you would be charged 84 equal monthly payments of about $81. The total interest assessed would be $1,354. That’s still significant, but it would trim nearly a decade and more than $6,000 in interest off the aforementioned minimum payment scenario. You could try to pay off the loan ahead of schedule to save even more money and time.
Here are some other key considerations:
Personal loan fees
Personal loans often charge origination fees. These can run as high as about 10 percent, so it’s important to shop around for the best deal. Origination fees are typically deducted from the amount you borrow, so if you’re charged a 10 percent fee and want to pay off $5,474 in credit card debt, you would actually have to ask for around $6,000 — including the fee.
Because of that, you might be better off applying for a personal loan with a lower origination fee, even if the interest rate is slightly higher. Some personal lenders don’t charge origination fees at all.
Consider other fees, too, such as prepayment fees (you’ll definitely want to avoid those if you plan on paying off the loan ahead of schedule). And recognize that interest rates can vary widely.
While some personal loans charge as little as 6 or 7 percent, the average is 10.60 percent. And the high end of the range — which represents what people with lower credit scores are charged — can exceed 30 percent in some cases.
Alternatives to personal loans
If your credit score needs some work, a debt management plan offered by a reputable nonprofit credit counseling agency might be a better choice. Money Management International, for instance, can often negotiate with your creditors and arrange a 6 percent rate over four or five years. That’s similar to the personal loan terms that are typically reserved for borrowers with the best credit, but nonprofit credit counseling agencies don’t require you to have stellar credit.
The average set-up fee for Money Management International’s debt management plans is $33, and the average monthly fee is $25. These can be a great deal. It’s worth noting that clients are generally expected to close the credit card accounts that they’re paying off. That may sound like tough love, but it can also be a beneficial way to set you up for success.
Another useful form of debt consolidation is to sign up for a 0 percent APR balance transfer credit card. These allow you to move your high-cost debt from one or more credit cards over to a new card that doesn’t charge interest, for up to 21 months. The main drawback is that this term is much shorter than many personal loans and debt management plans. The biggest advantage is you can completely avoid interest for nearly two years in some cases. Note that the typical balance transfer fee ranges from 3 to 5 percent, which runs between $164 and $274 in our example involving the average credit card balance of $5,474.
If you have a 21-month interest-free balance transfer offer and make equal monthly payments, you would need to pay about $261 per month in order to completely retire that $5,474 debt by the end of the term. That’s more than three times the monthly payment in the seven-year personal loan example, but you avoid interest entirely, and you’re debt free in a quarter of the time.
Balance transfer cards work best if you have good credit, are comfortable making these higher monthly payments and are a self-starter.
The bottom line
A personal loan might be your best option for paying down credit card debt if you have good credit and you’re comfortable managing your own finances, but you need a bit more time to knock out your balance. Personal loans tend to offer longer terms than 0 percent balance transfer credit cards.
Whichever debt payoff method you choose, make sure to keep your eyes on the prize. I suggest shifting your spending to a debit card or cash while you focus on knocking out your high-interest credit card debt. And forget about rewards for now, since it doesn’t make sense to pay 20 percent interest to get 2 percent cash back.
If you have credit card debt, seek the lowest interest rate for the longest period of time. For some people, that’s going to be a personal loan.
Have a question about credit cards? E-mail me at email@example.com and I’d be happy to help.