Using personal loans to consolidate debt
Debt consolidation with a personal loan
- Personal loans are an option to consolidate high-interest credit card debt.
- Use a personal loan to consolidate debt if the loan has a lower interest rate.
- Use savings from consolidating to pay down credit card principal amounts.
- Avoid accumulating more debt once your credit card balances are paid off.
When the bills pile up, a person can feel like they’re drowning. One way to consolidate debt is to take out a personal loan.
Borrowers often find it easier, psychologically and practically, to roll all of their high-interest credit card balances into one monthly loan payment. Through a personal loan with a fixed rate, borrowers also can limit the variable interest-rate fluctuation that comes with credit cards and lower the total cost of their debt.
The idea is that the overwhelmed borrower, through a personal loan, can use the loan proceeds and ongoing monthly payment savings to pay down credit card and other balances and ultimately get out of debt. Using this strategy also comes with serious risks, however, the biggest of which is that the borrower fails to recognize that paying down credit cards with a personal loan only shifts the debt load.
Although they can make their credit card balances disappear using the proceeds from a personal loan, they still have debt in the form of a personal loan. When all those high-balance credit cards are wiped clean, many borrowers develop a false sense that they have solved their problem. They don’t chop up their credit cards and change their spending habits, but instead go on a spending spree, racking up new credit-card debt on top of the personal loan and leaving them in a worse situation.
Secured vs. unsecured loans
A personal loan can come in two forms. One type is secured by the borrower’s savings, retirement account or personal property — typically their car or home. The other type is an unsecured loan, which is sometimes available to borrowers with good credit who can demonstrate through their income and work history an ability to repay the loan.
Credit card balances are unsecured loans, but some unsecured loans are designed to consolidate debts. They differ from credit cards in that they are paid out in a lump sum and often involve fixed monthly payments at a fixed interest rate.
There are pros and cons to each of these types of loans. Secured loans tend to come with lower interest rates, but they also have downsides as well. The biggest risk is that the borrower is putting their personal assets at risk should they default on the loan. The creditor can foreclose on the assets that have been used to back the loan.
Defaulting on an unsecured loan may not jeopardize other assets directly, but it likely will lead to litigation that could result in wage garnishment. Bear in mind as well that defaulting on any loan will damage your credit rating, making it much harder to secure future credit.
Another mistake people make is that they don’t sit down and calculate the costs and potential savings of the loan. Borrowers may be tempted to take out a high-interest debt consolidation loan that doesn’t provide any real savings.
Sometimes borrowers also are lured by teaser rates to transfer credit card balances, but fail to read the fine print and are charged hefty balance-transfer fees. Before taking out a personal loan or taking steps to consolidate debts, it pays for the borrower to weigh their options carefully.