If you're worried about how to pay off your holiday credit card debt, here are the pros and cons of taking out a personal loan.
If you're feeling a financial hangover after holiday shopping and have considered taking out a personal loan to pay off your credit card debt, you have a decision to make.
When I was young and struggling with a big decision, my mother would suggest I create a list of pros and cons. I'd get a piece of paper, draw a line down the middle, and on one side I'd write the positive things that could happen if I made a particular decision, and on the other I'd write the negative things that could result from that decision.
So, should you take out a loan to pay off holiday debt? Here's our list of pros and cons. Hopefully, it will help you decide.
Pros of taking out a personal loan
1. You may lower your interest rate
One of the main reasons for using a personal loan to consolidate your credit card debt is to access a lower interest rate. Make sure the interest rate on any personal loan you take out will be lower than the one you are paying on your credit card debt.
2. You can simplify your bill payments
Say you have five different credit cards. Consolidating them through a single loan will streamline the bill payment process and make it less likely that you'll overlook a bill. Lenders also often offer an interest rate discount if you sign up for automatic payments, which is a double win. You'll pay less in interest and never have to worry about forgetting to make a payment.
3. It can improve your credit score
Taking out a personal loan can sometimes improve your credit score. Although you should never take on additional debt solely to improve your score, if it already makes sense to do so, this could be an added bonus.
One of the things credit bureaus look for is a mix of credit. The greater the variety of credit types, the higher your credit score. For example, it is better to be making on-time payments on an auto loan, a credit card, and a personal loan than on three credit cards. Mix of credit accounts for 10% of your FICO® Score.
4. You may pay off your debt faster
It is possible you'll pay the debt off faster if you reduce your interest rate and don't commit to a lengthy repayment timeline. Make sure you read the loan terms carefully and sign up for an affordable monthly payment that does not increase the overall cost of your loan.
Cons of taking out a personal loan
1. Your interest rate is not guaranteed to be lower
Loan rates fluctuate and lenders have flexibility when it comes to setting those rates. As of today, the interest rates for personal loans range from 5.99% to 35.89%, depending on your credit score and the amount you need to borrow. The gulf between the two rates is massive.
To illustrate the difference, if you took out a $5,000 loan at 5% interest and paid it off in three years, your monthly payment would be $150 and you would pay $395 in interest over the life of the loan.
However, if you borrowed $5,000 at 35% interest, your payments would be $226 for three years, and you would end up paying around $3,142 in interest.
If the interest rate you're offered on a personal loan is very close to the rate you're paying on credit cards, you may be better off sticking with the cards and paying them off as quickly as possible.
2. You may be tempted to spend more money
If you borrow enough to pay back your credit card debt, it can be tempting to use the cards again and spend more. You may tell yourself that the pressures of the holidays caused you to rack up that debt, but you need to make a firm commitment not to spend more. If you don't take control of whatever made you depend on credit in the first place, you may find yourself with more credit card debt on top of your personal loan.
3. You increase your debt-to-income ratio
Taking out another type of loan is only beneficial if you keep your debt-to-income ratio (DTI) low. DTI refers to how much you owe in relation to how much you earn. Let's say your gross monthly income is $7,000 and total monthly debt payments amount to $3,500. Your DTI is found by dividing $3,500 by $7,000 to get .5 or 50%.
The lower your DTI, the better. For example, most mortgage lenders prefer a DTI below 43%, and some want it to be below 36%
4. You may have to pay loan fees
Some personal loan companies charge an origination fee, which is usually a percentage of what you borrow. Origination fees range from 1% to 8% of your loan amount. For example, if you borrow $5,000, you may be charged a fee of $50 to $400. If you are counting on every dollar of that loan to pay off holiday debt, remember to factor in the fee and borrow accordingly.
There is no doubt that the holidays can be wonderful, but debt is no fun. Weigh the pros and cons as they apply to your situation, do the math, and figure out which option works best for you. In the meantime, while you're paying off 2019 bills, you may want to make a plan to avoid more debt in 2020.