Millions of Americans are drowning in red ink. Is the answer to their problems a willingness to take on new debt?
It may sound crazy, but there are times when taking on new debt – in the form of a personal loan – could be a way to start the journey out of a huge financial hole, Says says Stephanie Yates, Interim Chair of Accounting and Finance at the University of Alabama at the Collat School of Business in Birmingham.
With this strategy, you take out a personal loan large enough to cover your Credit card debt fully. At that point, the credit card debt will go away and you will have to pay off the new debts on your personal loan.
“That would be a sensible strategy if the credit terms are better than the credit card,” says Yates, who is also director of the UAB Regions Institute for Financial Education.
Good Debt vs. Bad Debt
Americans are no stranger to credit card debt. U.S. households held an average of around $ 5,300 of such obligations at the end of 2020, according to this experience, one of the “big three” credit agencies.
Yates says most debts fall into one of two categories: good debt and bad debt.
Determining what type of debt you hold is based on “the useful life of the item purchased versus the length of the debt,” says Yates.
For example, taking out loans to purchase long-lived assets that will be paid off within their useful life – including homes, businesses, and colleges – is considered good debt. While these debts can be costly in the short term, they promise long term rewards in the form of a better financial future.
“Bad debt would be the opposite,” says Yates. In general, it is debts on items that have no appreciable value and that you have made payments on over a long period of time at a high interest rate. Credit card debt is typically considered “bad debt” because it often carries a high annual interest rate and can be expensive to pay back.
In many cases, personal loan debt can also fall into the bad category. However, it can be turned into “good” debt – or at least “better” debt – if you use personal loans to pay off credit card debt. This only applies if the terms of the personal loan – such as the interest rate and term – are better than the terms on the credit card you are trying to repay.
When does a personal loan make sense to pay off credit card debt?
“A personal loan at a lower interest rate than that Credit card plan would be a good choice if all other factors remained constant, ”says Yates.
Let’s say Wells Fargo touts personal loan rates that start at 5.74% on a $ 10,000 loan over a three year term. If you currently have $ 10,000 in credit card debt at the current average credit card rate – which LendingTree says is 19.49% – you can save a bundle on interest costs with a personal loan to pay off your credit card debt.
But not everyone qualifies for a personal loan on such favorable terms. This is especially true if your credit history is shaky and you have a low credit score.
If you don’t get the best terms and conditions, a personal loan may not save you much (or no) money compared to what you would pay if you left the debt on the credit card.
Many personal loan companies set a variety of interest rates on these products. Depending on your credit history and other factors, your interest rate can be as low as 6% or close to 20%.
Disadvantages of a personal loan
Even if you qualify for a high interest rate, some personal loans charge agency fees in the neighborhood of 1 to 6%. Others will charge you prepayment fees if they try to pay the balance early. If you have a particularly long repayment period, you may be able to pay more interest charges over the life of the loan than if you had left the debt on your credit card.
Additionally, your monthly personal loan payment is likely to be higher than the minimum payment you will need to make on your credit card. Paying more monthly can make life difficult when cash is particularly tight.
So before you take the plunge and decide, a. to use private loan To pay off credit card debt, make sure you fully understand the personal loan terms and conditions. “It’s important for consumers to be educated,” says Yates
She says some key factors that can determine if this is the right strategy for you are:
- The interest rate on your existing debt
- The personal loan interest rate
- The number of payment periods
- The amount of payment you owe each month
After carefully weighing all of these factors, you can determine that a personal loan is a good way to pay off your credit card debt.
However, if the number of payment periods and the resulting monthly payments resulted in a cash flow crisis, “the consumer might want to think again,” says Yates.
Tips for the best loan terms
The ability to get good loan terms will help you decide whether taking out a personal loan is the right strategy for you.
Yates points out that a longstanding relationship with a financial institution can help you approve the loan on the best terms.
When you develop a relationship with a financial institution and use it for multiple products – ex. You can build a track record with a bank or credit union – checking accounts, savings accounts, credit cards, and loans. “That can lead to lower rates and fees,” says Yates.
For example, Wells Fargo advises that customers with a qualifying Wells Fargo consumer checking account who make automatic payments from a Wells Fargo Deposit Account will be granted a 0.25% “relationship discount”.
“Don’t be afraid to look beyond the big banks when looking for the best personal loan terms,” says Yates.
“Credit unions have traditionally offered their members competitive rates compared to commercial banks,” she adds.
Alternatives to using a personal loan to pay off debt
Of course, a personal loan may not be the best option for paying off credit card debt. Like credit cards, personal loans are unsecured debt. That means they usually have higher interest rates than loans that are backed by collateral, such as your home.
Using a home equity loan or home line of credit (HELOC) to pay off your debts is another option. You will likely get a better rate on a home product because your home is used as collateral for debt. The Risk: Using a home equity loan or HELOC to pay off credit card debt puts your home at risk if you fail to make payments.
You may also want to consider credit cards that are over 0% balance transfer offers. This allows you to transfer your existing debt to a new credit card for a period of time – possibly up to 20 months – with no interest. This can save you time to pay off the debt cheaply. The risk: If you fail to pay your debts before the 0% transfer deadline has expired, the interest costs on your remaining debt can skyrocket.
Whichever route you choose, make sure that you are paying back your obligations as much as possible and not just dragging debt from one place to another. Many experts suggest that using one form of debt to pay off another form of debt is not at the root of your spending problem.
“If a consumer is interested in working aggressively towards paying off consumer debt, it is best to develop a debt settlement plan,” says Yates.
To start such a plan, check your budget to see how much you can afford to pay off the debt beyond your minimum payments. Then determine how you will use those payments to pay off your debts. Yates says the options include:
- Focus on the debts with the highest interest rate and pay off your most expensive debts first
- Pay off the debts with the lowest balance, then switch to the debts with the next lowest balance – the so-called “snowball” method that helps you build momentum by paying off one debt at a time
- Payment of the cards with the highest occupancy. This ratio is the amount of debt you owe compared to the debt you have in the form of credit. If you lower this ratio, you can improve your credit score.
Once you’ve paid off the debt, you won’t fall into bad habits. Instead, focus on developing better credit card habits. “Make an effort to be a ‘convenience user’ rather than a ‘revolving’ user by withdrawing funds every month,” says Yates.
At National Debt Relief, we pride ourselves on empowering people to regain their financial stability through our proven debt relief program. Contact us and speak to a financial professional who will work with you to find the best option to pay off your debt and help you achieve financial independence.