The mortgage meltdown and subsequent credit crunch spelled doom for an entire collection of risky mortgage related loan products. It also almost killed off the signature loan, also known as a personal loan. However, over the past year, the personal loan industry has made a strong comeback. The question for you is…are they right for me?
A personal loan is an unsecured installment loan. That means it’s a loan for a fixed amount of money to be paid back in equal installments over a period of month or years. And, there is no collateral securing the lender’s risk, like a car or a home, so there’s nothing to repossess if you default on the loan. And, loan amounts can be as high as an impressive $100,000.
If all of this sounds good to you, hold your horses. The news about these loans isn’t all good. First off, because of the unsecured nature of these loans, you’re going to have to have decent credit scores to qualify. And, if you think you’re going to borrow $100,000 then you better have an impressive income.
The interest rates for these loans can be pretty good or pretty bad. Some lenders will let you borrow for less than 5%, while others are going to hit you for over 20%, depending on your credit scores. So when it’s time to consider whether these loans make sense for you, it really becomes a matter of comparing the numbers.
The average interest rate on general use credit cards is between 13% and 15%, depending on whom you believe. Rates on retail store credit cards are much higher, around 25%. If you’re able to convert more expensive revolving debt to less expensive installment debt, that’s not necessarily a bad move. But be sure not to charge into those pre-existing credit cards or you may find yourself in debt twice over.
Look at your credit card statement and you should see a box that tells you how long it’s going to take to pay off your credit card balance if you just make the minimum monthly payment. You can thank the CARD Act for that. Depending on how much you owe and your interest rate, it could take you many years to exhaust your debt, and that’s assuming you don’t use your cards any longer.
With personal loans you don’t have that kind of endless horizon for paying off your balance. Some personal loans can be structured for no longer than 12 months, while others can be paid back over 60 months, like an auto loan without the auto. Either way, it’s likely that you’ll be done getting out of that debt sooner than you would if you fell into the minimum credit card payment trap.
Those who would argue that moving credit card debt to a 0% card offer would be right that it’s cheaper than an installment debt. But, they’d be wrong to suggest that you’ll be out of debt faster AND that your debt will be completely paid off at 0%. Those 0% offers have time limits ranging from about 6 months to almost 2 years, depending on the offer. Rates on installment loans are fixed for the duration of the loan term.
Using personal loans as a strategy for getting out of credit card debt will likely yield one immediate collateral benefit; it will improve your credit scores. Revolving credit card debt is much more punishing to your credit scores than installment debt. Many consumers have heavily leverage cards (cards where balances are too close to the limits) and several of them. This will disappear if you’re able to convert all of your credit card debt to personal loan debt. That means your debt to limit utilization percentage will drop to 0% and you’ll eliminate the balances on all of your credit cards. That’s the most actionable way to improve your credit scores quickly.
Further, these are loans issued by mainstream lenders that will be reported to the credit reporting agencies. That means you’ll get the credit building or rebuilding benefits that you won’t get from debit cards or prepaid debit cards.
At the end of the day, debt is debt. And, I’ve often used the phrase “borrowing from Peter to pay Paul” when describing these types of loans used for credit card consolidation. But, there is an undeniable difference between personal loans and credit cards when it comes to terms, rates and credit benefits. If you’re disciplined enough to use a personal loan as a way to get out of debt, rather than just delay getting out of debt, then they can be a smart financial tool.
John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a contributor for the National Foundation for Credit Counseling. He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of Mint.com or Intuit. Follow John on Twitter