The next time you’re out with a group of five friends, consider this — 4 out of 5 of you is likely dealing with some form of debt.
It's no surprise that Americans are deep in debt, but we don't always consider how close to home those mountainous loads of debt might actually be to us.
According to recent data from the Federal Reserve, nearly 80% of Americans hold some form of debt — with millennials leading the charge with having the most. These troubling figures add up to nearly $4 trillion of total debt.
If you're facing a sizable chunk of debt that needs to be paid off, you may have already thought about how to get a loan. But how good are personal loans for consolidating debt, and are there risks involved that you aren't aware of? It may seem counterintuitive to borrow money to pay off the money you've already borrowed or spent, but the best personal loans can actually be a saving grace to your financial situation. Keep reading while we go over the most common questions about using personal loans for debt consolidation and the factors you should consider.
What is an unsecured personal loan?
Do NOT let the word “unsecured” scare you. This type of loan isn’t like an unsecured website asking for your social security number. It’s a legit type of loan that doesn’t require you to put up any collateral in exchange for the loan.
For example, a mortgage loan’s collateral is the property it’s attached to, so the lender can sell the house to make back the money they lent if the borrower stops making payments. Title loans often use cars as collateral to incentive the borrower to repay the full amount.
Other than not needing any collateral for an unsecured personal loan, another main difference is interest rates are typically a bit higher than a secured personal loan. The bank is taking a big risk by loaning money without having anything but legal action to get it back. You should know that legal action can result in garnished wages if you’re not diligent about repayment.
Lastly, unsecured loans generally have shorter repayment periods and lower borrowing amounts.
Is it smart to get a personal loan to consolidate debt?
If only the answer were a simple yes or no, then making this decision would be much easier. In many situations, the answer is yes. Debt consolidation allows you to pay off all your debts with one payment each month and minimize the chances you forget to make a payment when managing several. You can say goodbye to late fees on forgotten payments when it’s all in one place.
However, there are other situations that a personal loan may not be a good fit for. A personal loan may NOT benefit you if:
- You want to pay off loans quickly (less than 2 years)
- You cannot manage your personal spending habits
- Your credit score is low
If you’re able and willing to pay off your debt quickly, the time and interest you’ll save through a personal loan aren’t worth it. Create your own plan to make larger lump payments toward your debt without consolidating. Potential borrowers with low credit scores may not be able to get a personal loan that is lower than the interest rates they are currently paying.
You’ll want to make sure you know the average of your interest rates and what your end game looks like without a personal loan before applying for one. If you’re consolidating your debt, you may end up in a position that gives you a higher interest rate overall which means you’d pay more money than if you hadn’t consolidated in the first place.
Let’s say you have $10,000 in credit card debt across two cards and each card has a balance of $5,000. One card has an interest rate of 20%, and the other has an interest rate of 10%.
The average interest rate of those two cards in 15%. If you can’t get a personal loan offer with an interest of less than 15%, you’ll end up paying more in the long run by consolidating that debt.
Are personal loans bad for your credit?
Accepting a personal loan does not have to hurt your credit. In fact, it could actually do the opposite. One factor of your credit score is something called “credit mix.” Credit mix means you have a variety of loan types, so adding a personal loan could be a positive.
Also, you’ll be paying off some other debt which will free up your available credit limit. That’s another positive hit on your credit score!
There are two ways for a personal loan to hurt your credit:
- You don’t use the loan money for its intended purpose (paying off existing debt), and now it’s just more money that you owe back.
- You break away from your repayment plan because the payment amount is too high or you don’t pay it for another reason.
Before you accept a personal loan, find out what the overall payment will be. If it’s not affordable to you, then you will want to look at other options for paying off your debt to avoid loan default.
When Personal Loans Make Sense For Debt Consolidation
You read earlier that there are money situations where borrowing a personal loan can benefit your finances. Here is where you’ll find out if you fit into that category.
A personal loan may benefit you if:
- You have a solid plan in place
- You have moderate debt that can be paid off in 5 years or less
- You have changed your spending habits and are serious about paying off debt
- You have good-excellent credit that qualifies for lower rates
- Balance transfer cards aren’t going to cut it
If you have a manageable amount of debt and you’re able to pay it off quicker than five years, you might consider using a balance transfer card to pay off your balance instead of borrowing a personal loan. Many credit cards have introductory 0% APR offers or low introductory rates when they’re first opened. If you can transfer your balance to a card like this, you can pay little to no interest if you’re able to pay off your debt before the introductory period is up.
Can I get a personal loan if I have poor credit?
Did you know there is such a thing as a “bad credit loan?” These loans should only be considered if you’ve exhausted all other options because the interest rates are insane! If you’re making at least the minimum payments on time, your score should rise each month if your balance doesn’t continue going up.
You’ll want to look at other methods to improve your credit score to become eligible for an unsecured personal loan before accepting that a bad credit loan is your only choice. Even for the most impatient person, give other tactics a chance for a few months. Set up a time with a financial advisor to look over all your options. There may be some that you aren’t aware of, and raising your credit score may be closer than you think.
The Bottom Line
It’s completely possible to pay off your debt with a solid plan and commitment.
Overall, personal loans are one of the most effective ways to get out of debt fast. Truly understanding your financial position will help you determine if consolidating your debt is the best path for you. Regardless of your fears, the future can be bright for you once you start asking the right questions and analyzing the real numbers without letting your emotions get the best of you.