If you have fairly good credit but high balances on your credit cards, it may seem like a great idea to take out a personal loan to pay off those cards. But depending on your debt payoff plan, using a personal loan to pay your credit cards could be like robbing Peter to pay Paul. Here are the issues you need to consider before taking out a personal loan to pay off your credit card balance:
How did you run up your balance?
If you had to use a credit card to pay for a major medical expense or other big bill outside of your control, using a personal loan to pay off the balance could potentially be a savvy way to lower your interest rate. After all, using a personal loan to clear your credit card debt is basically just exchanging one debt for another. If you can trust yourself not to get right back into credit card debt and you know that your high balance was a one-time anomaly, then a personal loan might be a good way to give yourself a little more control over your interest rate, your pay-off date, and your monthly payment.
But if your credit cards are out of control because you have difficulty keeping a tight rein on your spending, then using a personal loan to pay them off could really hurt your finances. Having your cards at a 0 balance could provide you with far too much temptation while you’re still paying off your last spending spree.
One decided benefit to shifting your debt from a credit card to a personal loan is the reduction in the interest rate. Depending on your credit score, interest rates on personal loans will almost always be lower that those on credit cards, which means you will end up spending less on your debt over the life of the loan. Although I have seen people effectively use balance transfer credit cards to get 0% interest for 12-18 months and make big dents in their overall debt.
Loan Term and Monthly Payments
A big difference between a credit card and a personal loan, however, is that the loan will have a specified loan term—generally no more than five years. Credit cards, on the other hand, have no specific amount of time within which you must pay off your balance (although the Credit CARD Act of 2009 does require card issuers to make sure the minimum amount due is high enough to make pay-off feasible within a reasonable time frame.)
What this means is that “shortening” your loan term could raise your monthly payment—potentially to a point where you might find it difficult to pay.
On the other hand, however, if you are able to “lengthen” your loan term, you might be able to lower your monthly payment and still pay less overall because of the lower interest rate. This, of course, would be the absolute ideal situation, but it might require some homework to find a loan that could do all that.
The Bottom Line
Using a personal loan to pay off credit card debt could potentially be a great tool for managing your credit card debt. But whether that tool will help or harm your finances depends upon both the terms of the loan and your ability to be disciplined about keeping your credit card spending in check. If you decide this is an option for you, then here are some tips on taking out a personal loan.