Psychology of Money

When It’s a Good Idea to Use a Personal Loan For Debt Consolidation

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Debt is a serious problem for Americans of all ages, and it hampers many big purchases and financial decisions.

According to Northwestern Mutual’s Planning & Progress from 2018, the average American has around $38,000 in personal debt, not including home loans and mortgages.

The total average amount of debt for a household in the U.S. is $135,065.

That’s an increase of $1,000 from the year before.

Additionally, according to that same study, fewer people reported having no debt as compared to 2017. In 2017, 27% of survey respondents said they had no debt as compared to 23% in 2017.

The biggest sources of debt for Americans, in order of how much the average American has of each, are:

  • Credit card debt accounts for 25% of all personal debt, and this is tied with mortgages
  • Behind credit card debt is student loan debt
  • Car loans

For younger Americans aged 18 to 24, student loans are the highest source of debt, which is then followed by credit cards.

For older Millennials aged 24 to 35, the average amount of debt is $42,000.

Credit card balances are the primary source of debt for older Millennials, often because of growing expenses as you get older.

Generation X, which is people who are 35 to 49, see an average debt load of $39,000, with mortgages representing the bulk of that and credit card debt behind that.

Baby Boomers, aged 50 and older have around $36,000 of debt on average, and as with people who fall into the Generation X category, their top sources of debt are mortgages, credit card bills and car loans.

Credit Card Debt in the United States

When we talk about personal debt, there are forms of debt considered “good” and “bad.”

Of course, for most people having no debt is optimal, but debt from home loans and student loans tends to be better than credit card debt or other types of consumer debt.

With a home loan, you’re building equity as you pay off your mortgage.

Student loans tend to have tax benefits that make them a bit better than other forms of debt.

Undoubtedly, the most toxic form of debt for most people is from credit cards.

Credit card balances from month-to-month went up to $423.8 billion at the start of 2019 according to an analysis from personal finance website NerdWallet.

The average U.S. household with credit card debt has an average of $6,741 in revolving balances, which are the balances that carry from month-to-month.

Around 9% of Americans with credit card debt report feeling as if they’ll never be free from it, and it often comes with high interest rates that make it feel like an endless cycle.

The average amount of interest households with revolving debt from credit cards pay annually is $1,141.

The burden of credit card debt is made worse by the rising cost of living and of course, the student loan debt crisis.

Even though incomes are growing for many people in the U.S., their costs are growing faster.

Good Debt vs. Bad Debt

Briefly touched on was the topic of good debt and bad debt.

Again, some might argue there’s no such thing as good debt however some forms of debt are the only way most of us are going to be able to buy high-priced items such as homes and cars.

Good debt is that debt you take on as a way to help you increase your net worth.

For example, student loan debt can be seen as good debt not only because of tax advantages but also because you can increase your earning potential if you receive higher-level education.

Good debt can also include a loan to start a small business, and debt used to purchase real estate since real estate can allow you to generate income.

On the other hand, car loans are considered bad debt because they depreciate quickly.

Of all forms of bad debt, credit card debt is one of the worst because of the high interest rates—usually much higher than the interest on a consumer loan.

How to Handle Debt

If you sit down and take a hard look at your finances, you may find that you have even more total debt than you initially thought.

When you have debt, some of the problems you may face include:

  • Debt, of course, costs money. You’re paying not only what you originally borrowed, but you’re also paying interest. The higher your interest rate, the more you’re paying.
  • When you have debt, it’s cutting into your future income and earnings. You’re borrowing money from your future earnings to pay for things in the present.
  • Having debt makes it difficult, if not impossible, to achieve other financial goals. For example, if you have a huge amount of credit card debt, you may not be able to buy a home or start a business.
  • Having a lot of debt puts emotional strain on you, and it can impact your mental and physical health.
  • Debt is also a reason for problems in many people’s marriages, and financial strain is one of the biggest contributors to divorce.
  • Around 30% of your credit score is based on the level of debt you carry. If your credit score is low, you might not be able to get other forms of financing, and it can even mean you pay more for certain products and services.

General ways to handle any type of amount of debt include:

  • Always be aware of how much you owe at any given time. You need to be able to see where you owe but also who you owe to, when payments are due, and how much payments are each month.
  • Pay everything on time and if necessary, use an app or software to keep up with payments. If you don’t pay on time, you’re going to end up paying even more because interest rates will go up and you’ll be responsible for finance charges.
  • Always make at least the minimum payment. It’s better to pay more when possible, but if you aren’t able to do that, pay at least the minimum.
  • Prioritize your debt, paying off the most toxic first.

Another option some people choose when they have debt is consolidation.

What is Debt Consolidation?

Debt consolidation is a way to pay off debt more quickly in some cases.

It means you get one loan and combine all your debt into that loan.

The biggest benefit of this is that you are only responsible for one monthly payment, rather than several or more.

Debt consolidation can also mean a lower interest rate.

Debt consolidation isn’t the same as doing something like debt settlement, because debt consolidation doesn’t negatively impact your credit score.

For a lot of people, debt consolidation can make dealing with debt psychologically easier.

There can be a sense that you’re taking control over your finances and that you’re streamlining your payments.

Even so, it’s important that when you use a debt consolidation loan, you’re not taking on more debt as you’re paying the consolidation loan.

Types of Debt Consolidation Loans

There are four general types of debt consolidation loans.

The first is a debt consolidation loan from a bank or credit union intended specifically for that purpose.

With a debt consolidation loan, you have to be aware that while you might get a lower monthly payment and lower interest rate, you may have a longer repayment period.

Depending on how long your repayment period is, you may pay more interest than you would have otherwise.

A home equity loan means you need to be a homeowner.

Your home becomes your collateral, and you need a decent amount of home equity as well as a good credit score to qualify.

The interest on a home equity loan tends to be very low, but if somehow you can’t make the payments on this loan your home may be foreclosed on.

A balance transfer credit card is a third option for debt consolidation.

With a credit card balance transfer, you find a card that has a 0% introductory APR or at least an interest rate lower than you’re currently paying.

If you transfer balances, you get a single payment and the benefit of paying less interest, but you’re not eliminating the interest you’ve already incurred.

You also have to be aware of how long the introductory APR period is, because if you don’t pay off the card within that time, you’re again going to be paying the interest rate on your remaining balance.

Using a credit card can negatively impact your credit score as well.

A personal loan is a fourth debt consolidation option.

Personal loans are unsecured and this type of financing has a fixed payment set over a period of time.

You do have to have a good enough credit score to be approved, and you also have to qualify for a high enough loan amount to cover your balances.

If you have good credit and you can qualify for a personal loan with a competitive interest rate, it can be a good option, but it’s not always the best way to consolidate debt.

Other Ways to Deal with Debt

Along with the primary options above, there are some other ways to deal with debt.

One option is debt settlement, but this should only be a last resort option.

With debt settlement, you can work out a deal to pay less than you owe, but it’s risky and can cause long-term problems.

For example, debt settlement often leaves a blemish on your credit report similar to filing bankruptcy.

You stop payment to creditors while the debt settlement company is negotiating the terms of your deal, so you’re going to have to pay interest from that time and companies that manage debt settlement usually charge a high rate of anywhere from 20 to 25% of the settlement amount.

Another option some people take to deal with their debt is to borrow from their retirement account.

The interest rates are low to do this, and you don’t have to complete a loan application, but you’re impacting your ability to earn compounded interest.

There are also tax penalties that come with borrowing from your retirement account, so again this isn’t an optimal option if anything else is available to you.

Debt management plans are sometimes confused with debt settlement, but they’re very different.

Debt management is a nonprofit approach to debt consolidation, and it doesn’t require a loan.

If you opt to go with debt management, you work with a credit counselor who then works with the people you owe money to.

They work out deals that will allow you to pay an affordable, fixed monthly payment.

Credit counselors can often negotiate lower interest rates with creditors, and it will stop collection agency phone calls.

It also gives you a structured plan and goal to work toward, and you can plan for your scheduled, single monthly payment.

Cons of this include the fact that there is a set-up fee and a monthly fee.

You can’t miss a payment, or you have to go back to paying the original interest rates, and you can’t use your credit cards anymore with the exception of a designated emergency card.

The Pros and Cons of a Personal Loan

A personal loan is usually unsecured, and in the best cases will have a lower interest rate than a credit card.

You can apply for a personal loan at a traditional bank or credit union, or you can apply online.

Depending on the lender you go with and the specifics of your loan, terms usually vary between 24 and 84 months.

The maximum loan amounts go from a few thousand dollars up to $100,000, and the lowest APRs currently offered on personal loans are around 5.95%.

Personal loans have become increasingly popular among consumers, with TransUnion reporting there were 19.5 personal loans in the U.S. in the second quarter of 2018.

That was an increase of 12.5% since the same time the year before.

The Pros of a Personal Loan

When you use a personal loan to consolidate existing balances, what you’re doing is refinancing your debt.

As with refinancing, when you combine your debt into one personal loan, you might be able to lower how much you pay every month and the interest you’re paying.

As of February 2019, the average interest rate on a 24-month personal loan is around 10.35%. The average rate on a credit card is 15.09%.

Also, as was touched on above, there are some personal loans with rates that are around six percent if you’re a very creditworthy borrower.

Along with the potential for lower interest rates, a big perk of a personal loan is that it gives you a clear path of repayment.

There aren’t fluctuations in how much you’re paying every month.

A personal loan is an installment loan.

You borrow a certain amount of money, for a certain time and pay it back in monthly installments which makes planning and budgeting easier.

It also can create the psychological benefit of showing you there’s an end to your debt repayment, which isn’t going to happen when you’re continually paying off revolving balances.

Another benefit of a personal loan is that you can typically get a relatively fast response and quick funding, especially if you work with an online lender.

The application and qualification processes are simple, and if you’re approved, you may receive funding within a few days.

The Cons of Personal Loans

Of course, as with most types of lending, there are downsides to personal loans.

If you’re using a personal loan to consolidate existing debt, resist the urge to feel as if you’re paying off the debt.

You have to remind yourself you’re not paying debt off—you’re transferring one type of debt into another.

When using personal loans for debt consolidation, there’s one big downside in particular.

If you clear your credit card balances with a personal loan, you may be tempted to start charging, and the whole cycle begins again.

A personal loan provides a very real opportunity to dig a bigger hole than you were in previously.

If you don’t have a strong credit score, you’re either not going to be approved for a personal loan or you’re not going to get an optimal interest rate.

For example, advertised rates on personal loans are often only for people with the highest credit scores.

Another downside of personal loans is the fact they often have fees attached to them.

These fees can range from 1 to 4 percent of the total loan amount and more in some cases.

These are called origination fees, and they’re on top of interest charges.

There are some lenders who charge other fees, including prepayment penalties if you pay your loan early.

These downsides make it extremely important that you read the fine print before accepting funding or a loan offer.

Personal loans tend to be linked with a lot of financial scams and unscrupulous borrowers as well.

There’s the sense that if you want a personal loan, you need fast funding and you might be more willing to take on very unfavorable terms to get it.

As a consumer, it’s important you research the background of any company you’re considering for a personal loan.

With a personal loan, while you do get the ability to plan as far as payments go since they’re fixed, that also doesn’t leave you with any wiggle room.

With a credit card, you have the option to pay only the minimum payment if money is tight in a particular month and you’re not going to have this option with a personal loan.

Is a Personal Loan the Best Debt Consolidation Option for You?

When you weigh the pros and cons of the different debt consolidation loans and options, it can be overwhelming.

You may realize you need to do something to tackle your debt and make it more manageable, but not all options are right for everyone.

First and foremost, if you don’t have good credit, you should consider an option outside of a personal loan.

The most favorable personal loan terms are generally reserved for people with good to excellent credit.

If you can get approved at all, with average or poor credit, you may be paying an interest rate on par or even higher than what you’re paying on your existing credit card debt.

Are you able to control your spending and credit card use?

This is something else to think about when you’re wondering if a personal loan is a good debt consolidation option for you.

If you believe you can control your spending and avoid accruing more debt when you consolidate with a personal loan, than it may be a viable option.

A few other factors that are relevant include:

  • Do you have a clear plan as to how you’ll repay a personal loan? You need to make sure that you have an idea of a realistic repayment plan that’s going to work with your income and your budget. If you get a personal loan and you struggle to repay it, you’re in no better situation than you were before.
  • How much debt do you have? If you have a moderate amount of debt, a personal loan may work for you. If you have high amounts of debt, a personal loan may not be enough of a solution. You may be better off with credit counseling.
  • Is your budget under control? If you’re not dealing with the root cause of your debt, then you may not find much benefit from consolidation with a personal loan. It’s a good idea to work out a budget and keep tabs on your spending before applying for a personal loan.

Final Thoughts

Personal loans for debt consolidation come with both pros and cons.

They tend to work better in some situations than others, so you should take an honest look at your debt, your budget, and your spending habits before making any decisions.

If you have a good credit score and a plan to repay a personal loan, you may be able to qualify for a competitive rate, and it can be a smart option for you financially as far as consolidation.

 

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