Should I use a personal loan to pay off my credit card debt?

When to use a personal loan to pay off credit card debt

There are certain situations where it makes sense to take out a loan although it’s important to assess your situation before rushing to borrow money to pay off other debts. Here are some examples of times when using a personal loan to pay off credit card debt might be a good idea:

• You have multiple maxed out credit cards with consumer debt
• You have medical bills to pay
• You need to cover costs for a big life event, like moving

Pros of using a personal loan

• To lower your interest rate. Perhaps the biggest potential benefit of using a personal loan is to lower your interest rate on the debt you owe. Typical credit card interest rates are around 19.99% to 25.99%. According to Statistics Canada , the average interest on a personal loan is 9.10%.
• Simplify your credit card payments. If you find it a lot of work to pay off multiple credit cards each month — say you miss a monthly payment just because it slipped your mind — consolidating your debt with a personal loan can simplify things for you. Even if it’s an innocent mistake, missing a payment can be costly and can lead to higher interest rates and late fees. By paying off your credit cards with a personal loan, you’ll only need to make one payment and you reduce the risk of lowering your credit score when you miss a payment. .
• A personal loan can help improve your credit score. When you take out a personal loan, you’re improving your credit mix, which refers to the different types of credit accounts you have. Having both credit cards and a personal loan means you’ll rely less solely on your credit card which can cause a bump up in your credit score. You can put your credit score on the upward trajectory by using less of your available credit and keeping your balance below 50% of your total available credit going forward.
• You can reach debt freedom sooner. If you’re just making the minimum payment on your credit cards each month, it can take you decades to pay them off. With a personal loan, it could cut down your repayment time significantly.

Cons of using a personal loan

• It could land you in more debt. When you take out a personal loan, it means you’re taking on more debt. This is fine as long as you use the debt in a responsible way. If you pay off your credit card debt with a personal loan and start running up the credit card balances again, you could end up with more debt than you began with. Instead of just owing money on your credit cards, you’ll owe money on a personal loan as well.
• Your credit score may impede you getting lower interest rates. One of the main reasons to take out a personal loan is to save on interest. While that is often the case, it’s not a guarantee. If your credit score has been negatively impacted by maxed-out cards and repeated missed payments, you’ll be considered a higher risk to lenders and your personal loan interest rate may be the same or even higher than your credit card interest rates. If that’s the case, you might want to explore a personal loan alternative like a balance transfer.
• There may be fees. Some lenders charge fees for personal loans. You may have to pay a fee if you have bruised credit,your loan payment is late, or there are insufficient funds in your bank account when the lender withdraws your monthly payment. Make sure you take the time to review the full schedule of fees before signing up.
• You’re committing to a fixed monthly payment. With credit cards, minimum interest payments are optional. With most personal loans you’re required to make higher payments that consist of interest and principal. Personal loans force you to pay down your debt. If you have irregular income, being tied to a fixed monthly payment can be tough. If you don’t earn a lot of income for one month, you may miss your personal loan payment.

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How to pay off credit card debt with a personal loan

A personal loan is also often referred to as a debt consolidation loan. When you consolidate debt or use a personal loan to pay off debt, the proceeds of the personal loan are used to pay off your existing credit card debt. When this happens, you’ll no longer owe any money on your credit cards (assuming the personal loan proceeds are enough to pay off your credit card debt). Going forward, instead of paying each of your credit cards, you’ll make a single monthly payment on your new personal loan.

Other ways to pay off credit card debt

Before you apply for a personal loan, consider these personal loan alternatives to get out of debt.

The debt snowball and debt avalanche methods

The debt snowball and debt avalanche methods are repayment tactics to help you get out of debt using a straightforward process.

The debt snowball method is a lot like rolling a snowball down a hill. It starts off smaller and then grows larger. Using the debt snowball method, you pay off your debts, the smallest balance to the largest balance, regardless of the interest rate.

With the debt avalanche method, the opposite is true. You’d focus on paying down the debt with the highest interest rate first.

Credit card balance transfer

A credit card balance transfer involves paying off one or several credit cards with a new credit card that has a lower interest rate. Sometimes the new interest rate is zero or close to zero. Essentially, you’re shifting credit card debt from one card to another. This makes sense when the credit card you’re shifting the debt to has a much lower interest rate and you have a plan to aggressively pay it down.

Unsecured line of credit

An unsecured line of credit is a lot like a credit card: it’s revolving debt. You can spend up to your predetermined credit limit. An unsecured line of credit makes the most sense when you are looking to lower your interest rate but aren’t able to commit to a regular fixed payment due to fluctuating income. By taking out an unsecured line of credit, it gives you the flexibility to aggressively pay it down when your cash flow is good and you make interest-only payments when your cash flow is tight.

Home equity line of credit (HELOC)

A HELOC is another form of revolving debt. It usually comes at a much lower interest rate because it’s secured by an asset—your home. If you already have a HELOC set up, you can use it to pay off credit card debt. If you don’t have one, there may be appraisal and legal costs involved in setting one up. The fees can usually be added to your mortgage or HELOC balance so you don’t have to pay them right away. A HELOC is beneficial for those whose cash flow is tight but want to pay a lower rate than a personal loan.

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Bottom line

If you’re looking to save on the interest on your debt, a personal loan can be a good choice. Using a personal loan to pay off a credit card can make sense if you have decent credit and you can get a personal loan at a lower interest rate than your credit cards. Just make sure you can afford the fixed monthly payments before signing up.

FAQ

How do I qualify for a personal loan?

Lenders consider several factors when qualifying you for a personal loan – your income, debt, assets, and credit score. The higher your income, the lower your debt and the better your credit score, the easier it will be to qualify for a personal loan at the lowest possible interest.

What do I need to apply for a personal loan?

Most lenders have a list of items needed to apply for a personal loan. Some common items most lenders will ask for include government-issued photo ID, your date of birth, social insurance number, employment status, home address, telephone number, email address, and a bank account that can accept deposits and make regular payments on the personal loan. If you provide that information to most lenders you’ll be golden.

What’s the difference between a personal loan and an installment loan?

In most cases, a personal loan and an installment loan are the same things. A personal or installment loan is when you receive a lump sum of money that’s used for a specific purpose (in this case it’s used to pay off your credit card debt). You’re then responsible for paying it back based on a fixed number of payments, otherwise known as installments.

How can I save on interest on a personal loan?

You can save on interest on a personal loan in two ways. First, do your homework and look for a loan with a lower interest rate. Secondly, consider paying off your loan over a shorter period. Before you sign up for a shorter loan term, make sure you can afford the higher payments. No sense in committing to a shorter term if you’re going to end up falling behind on payments.

Besides interest rate, what else should I consider when shopping for a personal loan?

Apart from the lowest interest rate, keep an eye out for the fees and flexible repayment terms. If your cash flow is tight, it may make sense to go with a loan with more flexible repayment terms, so you can choose a monthly payment that you can afford instead of stretching yourself too thin.

Sources

1. Statistics Canada: Funds advanced, outstanding balances, and interest rates for new and existing lending, Bank of Canada (Oct 16, 2024)