Should You Take Out a Personal Loan to Pay Off Credit Card Debt?
Taking out a personal loan to pay off credit card debt can be a sound financial decision for some people.
For example, if your credit card interest rate is high, using a personal loan to pay off your debt quickly can save you money. However, it’s not the right choice for everyone, as it might get you even deeper into debt depending on the loan terms, your financial situation, and the principal amount.
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The Growing Problem of Credit Card Debt
As of the fourth quarter of 2022, total credit card debt in the United States was $986 billion.
This amount officially surpassed the pre-pandemic high of $927 billion, indicating that U.S. consumers are in more debt than ever. Further, taking account of other forms of debt like auto loans, mortgages, and student loans, current total debt in the U.S. is $16.9 trillion — the highest of any country in the world. With the prevalence of this much consumer debt at all levels of society, people may be tempted to look for ways to consolidate their debt or lower interest paid.
As a result, some people consider personal loans as a solution. The reason is that personal loans usually have better terms than credit cards, and in most cases, they can help you save on interest payments.
How a Personal Loan Works
A personal loan is borrowed from a lender for personal expenses. It’s different from a mortgage or a student loan, as these are taken out specifically to pay for housing or education. You can use a personal loan to pay for nearly anything, including existing debt, a vacation, or even a boat. When you take out the loan, you have a fixed interest rate and monthly repayment schedule, so you know exactly what to expect in the future.
How Much Can You Borrow?
Generally, personal loans range from $1,000 to $50,000, though the actual amount you can borrow depends on factors like your personal credit score, income, and your debt-to-income ratio. The two main types of personal loans are secured and unsecured.
With secured personal loans, you put down collateral. The bank can seize this collateral as compensation if you fail to repay the loan. Because of this fallback policy, lenders typically offer higher borrowable amounts and/or lower rates for secured loans in comparison to unsecured loans.
An unsecured personal loan, on the other hand, doesn’t involve any collateral. Because you aren’t putting any money down, banks or other lenders might be more reluctant to offer better terms. Therefore, unsecured loans are generally for smaller amounts and have higher interest rates.
Are There Restrictions for Loan Usage?
Each lender establishes its own restrictions for personal loan usage. These restrictions can vary further depending on the purpose of the loan and the collateral involved. For example, many lenders prohibit you from using a personal loan for college tuition or making a downpayment on a home.
Check with the lender you’re considering to see if they have policies against using personal loans to pay off credit cards or any other restrictions.
Deciding Whether Getting a Loan to Cover Credit Card Debt Is a Good Idea
Getting a lower-interest loan with fixed monthly payments may sound like an excellent way to solve your credit card debt, but it isn’t the right solution for everyone. Consider the pros and cons of using personal loans to pay off credit card debt before choosing.
Personal Loan Debt vs. Credit Card Debt
Personal Loan | Credit Card | |
|---|---|---|
Interest Rates | Tends to be lower; fixed | Tends to be higher; variable |
Debt | One payment | Possibly multiple payments; one per card |
Repayment Plan | Fixed amount and term | Revolving; potentially no end date |
Fees | Origination fees; late payment fees | Annual fee; late payment fees; foreign transaction fees |
Best For | Large purchases | Small purchases that can be paid off almost immediately |
As you can see, personal loan debt and credit card debt are quite different, so weighing the pros and cons for your personal financial situation is essential.
Benefits of Using a Personal Loan to Cover Credit Card Debt
If you’re considering using a loan to pay off credit cards, you may find it possible to save some money in the long run. With regular, fixed payments, you can better manage your finances and avoid falling into more debt. Here are some potential advantages of using a personal loan to cover credit card debt.
Consolidating Your Debt
If you have debt spread across several credit cards, paying the minimum monthly balance on each card might be challenging. Consolidating your debt into one personal loan eliminates the confusion and gives you a single payment to worry about. You don’t have to juggle multiple interest rates or due dates, and you can establish a clear deadline to finish your payments, therefore eliminating the risk of making payments late.
Potentially Lower and Fixed Interest Rate
Credit card interest rates are notorious for being higher than other forms of debt. In September 2022, the average annual credit card interest rate was 17.96%. Meanwhile, during that same period, the average annual rate for an unsecured, 36-month fixed loan from a bank was 10.16%.
Also, personal loan interest rates are fixed, meaning they don’t change after you take out the loan. Credit card interest rates, however, can go up or down depending on the current interest rate environment, meaning your payment terms could change without warning.
Potentially Lower Monthly Payments
If you can get a personal loan with a lower interest rate, your monthly payments could be lower than what you have with your credit card debt. However, a lower interest rate isn’t the sole factor in lowering your payments. Because you can choose a fixed term for your personal loan, you can potentially spread out your payments over a longer period, helping lower your monthly payments.
Set Plan for Repayment
Personal loans are for a fixed amount of money and time. They’re not like credit cards, where you can keep adding on debt each month. Because of that, you have a fixed plan for repayment. As long as you follow the payment schedule, you’re guaranteed to be out of debt by a specific time and possibly faster if you make extra payments. Since credit cards have variable interest rates and no set deadline for repayment, it can sometimes feel like there’s no end in sight.
Potential to Boost Your Credit Score
While applying for a loan can temporarily lower your credit score because of the hard credit check, a personal loan could raise your score over the long term. When you use a personal loan to pay off your credit card debt, you lower your total credit utilization, a factor that makes up as much as 30% of your credit score. The ideal credit-utilization ratio is between 1% to 10%, however, the general rule is to keep it below 30%. Personal Loans don’t count toward credit utilization, which can help lower this number and boost your score. However, keep in mind that personal lines of credit do.
Drawbacks of Using a Loan to Cover Credit Card Debt
While there are a lot of potential benefits to using a loan to pay off your credit card debt, there are also several cons. For some, these cons might mean you’re better off paying your credit cards without a loan.
Potential For Excessive Costly Fees
Taking out a personal loan isn’t free, and some fees are associated with the process. In fact, you may pay about 1-5% of the total principal back in fees, which does not include interest. The most common are:
- Origination Fees are the amount of money the lenders require to process your loan.
- Documentation Fees are a one-time charge that pays for handling the paperwork associated with the loan.
- Credit/Disability Insurance Fees are a form of insurance that covers your payments should you become disabled or pass away.
- Late Fees are a penalty for non-payment or late payment of your loan.
Personal Loans May Not Have Lower Rates or Payments
While many personal loans come with lower interest rates than credit cards, it’s not guaranteed. The rate you’re offered depends highly on your credit score. If your credit score has dropped because of your credit card debt, you may find that a loan doesn’t offer the cost savings you want.
Still, it’s worth talking to a lender to see if consolidating credit card debt with a personal loan would yield lower interest, monthly payments, or better terms.
Potential for Additional Debt
Personal loans can be good if you’re committed to getting out of debt. However, if you do not have a solid financial plan and take on additional debt after consolidating with personal loans, you could end up in worse financial shape than before.
Potential to Lower Your Credit Score
While a personal loan can raise your credit score in the right circumstances, it can also lower it if things go awry. For example, if you fall behind on payments, this gets recorded on your credit report. Your payment history can make up as much as 35% of your credit score, so missing several payments will negatively impact your credit score.
How to Get and Use a Personal Loan to Pay Off Your Debt
If you think using a personal loan to pay off your debt might be a good choice for your situation, there are a few steps you need to take to secure a loan. Consider the following process to know what to expect moving forward.
1. Calculate the Loan Amount You Will Need
Knowing how much you need to borrow isn’t as simple as adding up your current credit card balances. You also need to consider any interest you owe and any late fees or payment penalties you may need to pay on your credit cards. Further, its crucial to consider any pending charges on your credit cards.
Once you have your estimated total, double-check with your credit card companies to ensure you have the correct amount. You may also want to take out an additional amount if you want to cover any personal debts such as home renovation. Remember, your credit score can be negatively impacted slightly each time you apply for a loan, so it’s best to get a single loan rather than apply multiple times.
2. Compare Your Lender Options and Get Quotes
Lenders sometimes have wildly different quotes when it comes to loans. Narrow it down to three to five lenders, and then get an estimate from each to see what they have to offer. Make sure you’re asking for the same loan type, rate type, and term on each loan, or you may find it harder to see how the loan offerings compare.
One of the main things to look at is how the estimated monthly payments compare, but here are a few more questions to ask each lender:
- Is the interest rate locked or variable?
- Are there prepayment penalties?
- What are your origination fees?
3. Formally Apply for the Loan
Applying for a loan usually involves filling out an application and submitting documentation.
When you’re applying for a loan, the lender needs to see your full credit report and proof of your current financial situation. That means they may ask for documents such as:
- Paystubs from the last few months
- Tax returns from the past few years
- Checking or savings account statements
- Any retirement assets or other investment holdings
They also need to verify your identity, so they may ask to see your driver’s license, proof of address, Social Security card, or other identifying documents.
4. Receive Your Loan and Use It to Pay Off Your Credit Card Balances
Usually, personal loans are deposited directly into your bank account. Your lender might ask for the account information where you want the loan deposited during the application process. Keep in mind that sometimes lenders require you to provide the credit card account number and information if you specified the loan proceeds for credit card debt during the application.
This means it’s up to you to manually pay off your credit card debt. You can usually do this simply by submitting an online payment. Resist the temptation to use the funds for something else, as this could land you in financial trouble.
5. Begin Repaying Your Loan
Many banks require you to repay your loan 30 days after they disburse your funds. Some may also give you until the first of the next month. Ensure you know your payment due date; you can find this on your loan paperwork or online account.
An easy way to be on time is to initiate automatic payments if your lender offers it. If you don’t like auto-pay, consider making two bi-weekly payments that coincide with your paycheck. This helps you pay off your loan faster and can help keep you consistent. Keep in mind that some loans have repayment fees which could end up costing you even more money. Check with your lender to determine if these fees are part of your terms.
6. Pitfalls to Avoid
A personal loan is an excellent tool for helping you manage your debt, but it’s not a get-out-of-jail-free card. Make sure not to fall into these pitfalls:
- Remember that a personal loan is still debt: While personal loans aren’t revolving like credit cards, they’re still money you owe a third party. Banks can still send collection agencies after you or take your assets as collateral if you fail to repay.
- Try to limit future credit card usage: To ensure you don’t fall into a cycle of debt, it’s important to reduce your overall spending. You may need to analyze your credit usage, so you don’t get deeper into debt.
- Ensure you have a sustainable repayment plan: If your new monthly payment is too high to manage, you will likely fall into default.
- Be wary of debt settlement programs: Debt settlement programs can be predatory and require you to stop paying your bills for several months, which could tank your credit score and put you still further into debt.
Alternatives to Personal Loans for Handling Credit Card Debt
Some alternatives exist to using personal loans to pay off credit card debt. If you don’t think a personal loan is a good idea, you can use a credit card balance transfer, another type of loan, or even negotiate with the card issuer.
Credit Card Balance Transfer
A credit card balance transfer is when you move your credit card debt from one credit card account to another. Ideally, you move the debt to a credit card with a 0% introductory APR, as there isn’t any interest during the introductory term, usually 12 to 24 months interest-free.
Balance transfer credit cards are a good option if you can qualify for a 0% intro APR card and need a few months to pay off the debt. However, it might be harder to qualify if your credit score has taken a hit from your debt.
Keep in mind that balance transfers can negatively affect your credit score, usually temporarily. Once your credit report reflects the new account, as well as the old account paid to $0, your credit score will typically improve.
Pros and Cons
If you need a few months to pay off your debt, balance transfer credit cards give you that time without an interest penalty. You can sometimes even move other types of debt, like an auto loan or personal loan, over to a 0% intro APR credit card.
However, many cards charge transfer fees. These can be around 3% to 5% of your total balance but still may be less than your current credit card interest rates. Additionally, once the initial offer ends, if you still have debt on the account, it will be subject to the interest of the new credit card, sometimes as high as 20-30%.
Credit Counseling
Credit counseling involves seeking help from an advisory service that can guide your repayment efforts. For example, they might be able to help you make a budget and establish a debt management plan. They may even be able to negotiate with creditors to lower your interest rate.
Credit counseling is a good option if you have the resources to pay down your credit card debt but don’t know where to get started. However, keep in mind that these services also charge a fee.
Pros and Cons
Credit counseling is an excellent resource to help you become more financially savvy. Counselors offer free learning materials, workshops, and a complete plan to help you get back on track with your finances.
Conversely, credit counseling can’t reduce your debt or guarantee a lower interest rate. Their primary function is to teach you the skills you need to better manage your money, which might not feel helpful when you need to quickly pay off debt.
Work With Credit Card Issuers to Negotiate Lower Rates or Repayment Plans
Sometimes, a bank might be willing to negotiate a lower rate or repayment plan for you. That’s because banks would instead get more of their money back than nothing, especially if you end up filing for bankruptcy.
These hardship agreements are a good idea if you have some life event that’s made it hard to make credit card payments, such as divorce, large medical bills, or a medical disability.
Pros and Cons
Getting a lower interest rate or a set repayment plan can save you thousands of dollars and prevent you from eventually filing for bankruptcy.
However, it’s not easy to negotiate with card issuers. After all, they want what you owe them. Negotiating a lump-sum agreement, where you pay a lower amount than you owe in one large payment to settle the debt, can also increase what you owe in taxes. Any debt that is canceled or forgiven is subject to income tax and must be reported on your income tax return during the year in which the debt was forgiven.
Self-Driven Repayment Methods
If you have the determination, several proven methods can help you pay down your debt on your own. One of these is the snowball method, a strategy where you pay down your smallest debts first. For example, if you have three credit card balances of $500, $1,500, and $3,000, you’d pay the minimum payment on each card but put extra money into paying off the $500 balance first. This helps you tackle your debt from the ground up, and is an easy way to show quick progress on paying down your debt.
The other method, the avalanche method, focuses on paying the debts with the highest interest rate first. So if your three cards had interest rates of 10%, 15%, and 20%, you’d pay the minimum payment on each card but work on putting extra down on the card with the 20% interest rate first, regardless of balance.
Pros and Cons
With the snowball method, you may be more motivated as you pay off small loans faster. It’s also an easy system to use. However, it usually results in you paying more interest overall and can slow down your total debt repayment.
The avalanche method has the bonus of reducing the overall interest you pay and helping you get out of debt faster. However, it’s not as gratifying as the snowball method, as it may take a long time to pay off even one loan.
Both methods depend on your commitment to following through, so they may not be a good choice if you struggle with financial self-discipline.
Take a 401(k) Loan
With a 401(k) loan, you can borrow from the money you’ve put away from retirement. While you have to pay interest on what you borrow, this interest goes back into your account. If you don’t pay back withdrawals you make before age 59 1/2, you must also pay a 10% tax.
A 401(k) loan might work for you if you have a robust retirement account and can sacrifice a small portion without jeopardizing your financial future. Also, keep in mind that not all employers allow this strategy.
Pros and Cons
Because your 401(k) money belongs to you, you’re borrowing from yourself, so you don’t have to have a good credit score or collateral to get a loan. Additionally, the interest you pay on the loan goes back into your account.
However, 401(k) loans are risky, not because of the interest and 10% tax you pay. Taking money from your retirement account could drastically derail your savings. You also have only five years to repay the loan; if you leave your job, you may even be forced to repay it sooner. Further, loans cannot be taken from IRAs and are applicable to 401(k)s only.
Home Equity Loan or Line of Credit
You might be eligible for a home equity loan or line of credit if you’re a homeowner. These let you borrow against the equity you’ve paid into your home. A home equity loan is a one-time disbursement of a set amount, whereas a home equity line of credit lets you pull money as you need it up to a certain amount over a set period.
Both could be a good option if you’ve paid off at least 20% of your mortgage and need some quick cash.
Pros and Cons
With a home equity loan, you can usually borrow up to 85% of your home’s value minus any debt that you owe, meaning you can easily pay your debts if you have significant equity in your home.
However, because your home is the collateral for the loan, you could lose your house if you go into default. It’s a considerable risk, especially if you’re not confident you can repay the loan on time. Furthermore, many banks don’t allow you to take out a home equity loan if your debt-to-income ratio exceeds 43%, which may be the case if you have significant credit card debt.
The Long-Reaching Impacts of Credit Card Debt
Consumer credit increased by 7.9% in 2022, meaning more and more people are relying on products like credit cards to help them pay their expenses. As consumers increase their debt-to-income ratios and make late payments, they may find it more difficult to get loan products when needed. Even if they are eligible, the attached interest rates could be unaffordable.
As more and more people go into credit card debt, it’s affecting more than their financial health. Consumers’ mental health may also be at risk. The study looked at 7,900 baby boomers and found that people who consistently had a high level of debt throughout their life were 76% more likely to have daily pain. This might be because they’re worrying about money, but it also could be because they don’t have enough resources to pay for major or preventive healthcare.
What This Means For You
If you’re struggling with credit card debt, it’s a good idea for your ovearll health to try and sort it out as quickly as possible. It might take a bit of strategy and planning, but in the end, it can offer considerable benefits to your overall well-being.
When considering whether or not a personal loan is a suitable choice for getting out of debt, consider the mental and physical benefits as well. If you think being unburdened by debts would be a massive weight off your shoulders, it may be worth the additional risk involved.
You have other solutions even if you decide against a personal loan to pay off your credit cards.
A credit card balance transfer, 401(k) loan, home equity loan, or line of credit can also be pathways to a debt-free life. If you’re wary of taking out a loan to pay for a loan, you might consider negotiating with the credit card issuer, utilizing credit counseling, or buckling down and devising your own payment strategy.