Many people who are struggling to get out of credit card debt and better manage their finances have considered consolidating their debts with a personal loan. If you have unexpected emergency expenses (such as a major car repair) and do not have a "rainy day" savings fund, getting a personal loan might be a better financial option than getting another credit card.
Here are the answers to a few of the questions you may have if you are trying to decide between getting a personal loan and applying for a credit card:
What are Personal Loans?
Personal loans can include any type of secured or unsecured loan that is issued by a bank or credit union. A "secured loan" is a type of loan where the lender requires you to put up some valuable asset as collateral – for example, your house or your car.
Mortgages and home equity loans are secured loans backed by your house – if you fail to repay your loan, the lender can repossess your house. Unsecured personal loans function in the same way as a credit card – the debt is not backed by any financially valuable asset, and so to manage its risk, the bank can require you to pay higher interest rates.
Unsecured personal loans offer a bit less risk for you, the borrower - because you do not run the risk of losing your home, car or other assets as you would with a secured loan - but the bank can still sue you to collect what is owed if you fail to repay.
What is the Difference Between Unsecured Personal Loans and Credit Cards?
The difference between unsecured personal loans and credit cards is that personal loans give you a definite repayment period where you have to repay the money that you have borrowed.
Credit cards give you a "credit limit" that you can borrow as much or as little of as you want – and there is no definite deadline for repaying the money after you borrow it. You can pay just the minimum balance on your credit card each month, or you can pay off the entire amount that you owe.
The advantage of getting a personal loan to consolidate debt is that it gives you a fixed payment each month so that you can get out of debt in a certain amount of time – while many credit card borrowers make the mistake of only paying their minimum payments each month, and end up taking many years to get out of credit card debt.
One possible disadvantage of using personal loans to consolidate debt is that depending on the amount of credit card debt you consolidate, you might end up with a higher monthly payment than you had when you were just slowly paying off your credit cards.
You can figure out whether you’d be better off with a personal loan or credit card by using this credit card minimum payment calculator. If you can pay off your personal loan faster than you can by making the same payments on your credit card balance, then a personal loan might be the best option.
When does a personal loan make more sense?
A personal loan is often the best choice if you…
Have to pay off a one-time emergency expense
Emergency expenses such as major car repairs or home improvements are good examples. You can often get a lower interest rate by taking out a personal loan for a specific amount of money, rather than borrowing more money on your credit card. CreditLoan's Personal Loans section can provide more information. Remember, many lenders have interest rates which are generally lower than a credit card.
Can get a lower interest rate on a personal loan than you are paying on your credit card debt.
Personal loans often offer slightly lower interest rates than credit cards, depending on your credit score. According to the Federal Reserve, the average interest rate on a 24-month personal loan (as of Feb. 2012) was 10.88%, which was less than the 13.04% interest on credit card accounts.
Want to consolidate credit card debt and pay off all of your debt in a fixed period of time.
Personal loans for debt consolidation can be a good deal if they help you get a lower interest rate than you were paying before, and/or if they lower your monthly payment.
One additional disadvantage of personal loans, depending on the terms of the loan you take out, is that there might be a prepayment penalty. A prepayment penalty is an extra fee that the lender charges you if you pay off your loan sooner than planned. Not all personal loans have prepayment penalties, but be sure to ask and read the fine print before you sign.
This sample Truth in Lending disclosure form from the Center for Responsible Lending shows the contract language for a mortgage that indicates whether or not the loan includes a prepayment penalty. Watch for similar language in your loan contract before you sign. Many banks do not charge prepayment penalties on any personal loans, and they will advertise this fact. For example, Wells Fargo does not charge prepayment penalties for its personal loans.
Taking out a personal loan can be a better financial move than simply adding more credit card debt. However – if you choose to consolidate your credit card debt with a personal loan, keep in mind that this does not make the credit card debt "go away." It just moves the credit card debt into a new form – and you will still need to keep making your monthly payments.
But if you need quick cash to pay off a major expense, or if you want to reorganize your financial life to pay off your credit card debt faster, a personal loan might be a good solution to help put your finances on the right track.