Debt Relief Experts
Paying down credit card debt can be challenging if you carry large balances.
We explain the benefits and potential drawbacks of using a personal loan to pay off credit card debt and provide other debt relief options you may want to consider.
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Personal Loan vs Credit Card Debt
Personal loans and credit card debt are both common forms of borrowing money, but they have different structures and repayment requirements.
A personal loan allows you to borrow a specific amount of money and repay it over a fixed repayment term, which can range from a few months to several years. Most personal loans are installment loans that have a fixed interest rate, and you make fixed monthly payments until the loan is paid off.
In contrast, credit cards are a revolving line of credit, meaning you can borrow up to your credit limit, pay it down, and borrow again. Credit cards require only a minimum monthly payment, but carrying a balance means paying interest on the remaining debt. Making only minimum payments keeps you in debt indefinitely.
Understanding this difference, why would you use a personal loan to consolidate credit card debt?
Pros of Using a Loan to Pay Off Credit Card Debt
Using a personal loan to pay off credit card debt can provide several benefits in terms of financial management and cost savings. Here are some key advantages:
- Lower interest rates: Most personal loans offer lower loan rates than credit cards, especially if you have good credit. Credit card interest rates are high, which means most of your monthly payment goes towards interest costs. Lower rates mean you will pay less in interest over time, saving you money.
- Fixed repayment date: Since most personal loans have a fixed repayment term, you will have a clear end date for when you will get out of debt. Since you can’t reborrow on the same loan, there is less risk that your balances will grow again.
- Fixed monthly payment: Personal loans typically carry a set monthly payment. This can help with budgeting and money management, as you will know exactly how much you must pay monthly.
- Simplified finances: Consolidating multiple credit card debts into a single personal loan can simplify your finances. Instead of managing multiple payments with different due dates, you have just one payment each month.
- Improved credit score: Paying off credit card debt with a personal loan can improve your credit score. Reducing your credit card balances can lower your credit utilization ratio, which is a significant factor in your credit score. Most personal loans are also considered installment credit, which can diversify the credit mix on your credit report and positively impact your credit score. Consolidating your debt may make keeping up with your monthly payments easier, so you avoid future late payments and show a good credit history. Regular, on-time payments on your new personal loan can boost your credit score.
- Getting out of debt sooner: Paying less interest and having a fixed debt repayment date can help you get out of debt sooner, but only if you avoid the temptation to drive your credit card balances up again.
- Reduced mental stress: Consolidating debt into a single loan can provide psychological relief. The stress of managing multiple debts can be overwhelming, and simplifying your debt into one payment with a target date for when you will be debt free can reduce anxiety and improve your overall mental health.
Risks Using a Personal Loan to Pay Off Credit Card Debt
While consolidating credit card debt with a personal loan can offer benefits, there are also potential drawbacks.
One significant risk is that it does not address the underlying spending habits that led to your high credit card balances in the first place. Paying down your credit card balances means you have more available credit. You may be tempted to use your credit cards again, risking more debt.
While a personal loan’s fixed monthly payment makes it easier to manage your finances, that payment may be higher than the minimum payment on your credit card. Your monthly payment is also not flexible if your financial situation changes.
If you do not have a good credit score, you may be denied a personal loan or may face interest rates as high or higher than those charged on your credit cards.
Lastly, some loans have additional fees, such as prepayment penalties, origination fees, or other lender fees, which increase the overall cost of borrowing.
Best Loan Options for Consolidating Credit Card Debt
Worried about your credit card debt?
It’s important to consider your options when paying off credit card debt in Canada. Choose the one that best suits your financial situation and goals for paying off your debt. Here are some personal loans commonly used to consolidate credit cards:
Term or installment loan
A term loan, or installment loan, has fixed repayment terms, a fixed rate, and fixed monthly payments. You would borrow as much as you need to pay off your credit card balances and other bills.
Traditional financial institutions such as TD, RBC, Royal Bank, and credit unions generally offer lower interest rates and are a good option if you have good credit.
Installment loans can either be secured or unsecured. An unsecured personal loan does not require collateral. With a secured loan, you must use something as collateral, like your car or house. This guarantees your lender that you will repay the borrowed amount, and if you fail to make payments, they can seize your car or house.
Line of credit
While a credit card is a revolving line of credit, most carry an annual percentage rate between 18% and 24%.
Bank lines of credit typically have lower interest rates than credit cards, making them a good choice for consolidating credit card debt. Transferring your balance to a line of credit can help you save money on interest and pay off your debt faster.
The actual rate you will be charged depends on factors such as who you are borrowing from, your credit score, and the nature of the credit line (whether secured or unsecured).
It’s important to note that lines of credit generally feature variable interest rates. Consequently, if the creditor’s prime rate rises, your interest cost and monthly payment will increase.
Debt consolidation loan
A debt consolidation loan involves taking out a new loan to pay off existing debts. It can be used to combine multiple credit card debts, overdue bill payments, store cards, and other unsecured debt into a single loan with one monthly payment.
Debt consolidation loans are available through a wide range of lenders, including banks, credit unions, and online lenders. More traditional financial institutions will offer lower interest rates. Online or subprime lenders, who specialize in debt consolidation loans for those with poor credit, charge much higher interest rates. Avoid a debt consolidation loan if the interest rate is higher than the rate charged on your credit card.
Mortgage refinancing
If you are a homeowner, you may be able to consolidate credit card debt into your home mortgage.
Mortgage refinancing involves taking out a new mortgage and borrowing extra to pay off credit card debt. Since it is a first mortgage, refinancing offers the lowest interest rate, but there can be pre-payment penalties on your current mortgage if you are trying to refinance before the renewal date.
It’s also possible to take out a second mortgage secured against the equity in your home. This leaves you with two mortgage payments. Interest rates on second mortgages are higher than a regular mortgage. The rate will depend on your loan-to-value ratio (the percentage of the current market value of the property you borrow). Most lenders limit LTV ratios to 75%. Secondary or alternative mortgage lenders may allow for a higher-ratio mortgage, but the interest rate will be very high, and additional fees may be involved.
A Home Equity Line of Credit (HELOC) also uses the equity in your home as collateral. A HELOC provides payment flexibility as you are often only required to pay interest only, or interest plus 1-2%. If using a HELOC to pay off credit card debt, have a plan to pay down the balance.
Balance transfer credit card
While not exactly a loan, a balance transfer credit card is an option you could consider to help manage your existing debt. These cards often come with a low or 0% interest rate for an introductory period, allowing you to transfer your credit card balances and save on interest charges for a while. It’s a great way to consolidate your debt and make it more manageable. Remember to monitor any balance transfer fees and know how long the introductory period lasts.
Sometimes, a balance transfer can positively impact your credit and help you pay less interest on your debt payments in the long run. When you open a new card to transfer a balance, you will increase the available credit amount, lowering your credit utilization rate. Just stay focused. Repeatedly opening new credit cards and transferring balances can damage your score in the long run.
Title loans
A title loan allows you to borrow money using your vehicle for collateral. An option for those with bad credit, they usually do not require a credit check. These loans come with steep interest rates, fees, and short loan terms between three months and three years. There is also a significant risk: you can lose your vehicle if you don’t repay the loan. Due to the high cost and risk, we do not recommend title loans to pay off credit card debt.
Payday loans
We do not recommend taking out a loan from a payday lender. Although a payday loan may seem like a good idea, it must be repaid within two weeks, which is likely not feasible. At $15 per $100 borrowed, the interest rate on a payday loan is equivalent to 391% a year, much higher than the rate charged on your credit card.
Payday lenders also offer installment loans; however, they charge the highest interest rate among all lender options for these types of loans. Rates can be as high as 39%-59% plus fees and mandatory insurance charges.
Borrow money from family and friends
If you have family members who can help financially, it may be time to ask for help. The key is to approach the conversation with openness and transparency. Work with family members like any other lender. Have a written loan agreement, including interest charges and repayment terms. Avoid strained relationships by making payments on time.
If you have poor credit, asking someone to co-sign your loan may be necessary. Make sure you and your co-signer understand the full implications of such an arrangement. If you stop making payments, the lender will contact your co-signer and expect them to repay the loan in full.
Non-loan Debt Relief Alternatives
But what if you don’t qualify for or can’t afford any loan to consolidate your credit card debt? Let’s consider some non-loan debt relief alternatives to paying off credit cards.
Debt management plan: A debt management plan (DMP) involves enrolling in a repayment program through a credit counselling agency. It’s not about taking out another loan but creating a structured plan to repay the debts you owe. You must be able to pay back your debts in full. However, your credit counsellor may be able to negotiate a lower or no-interest plan. However, an additional charge to the credit counselling agency will be included in your monthly payments.
Consumer proposal: Consider a consumer proposal if you cannot afford to repay your credit card debt in full. A consumer proposal is a formal arrangement made with creditors through a licensed insolvency trustee. It involves negotiating with your creditors to repay a portion of your debts over an extended period, usually up to five years. This agreement allows you to make manageable monthly payments based on what you can afford while also providing legal protection from further collection actions by creditors. A consumer proposal does not require you to surrender your assets and has less impact on your credit score than bankruptcy.
Bankruptcy: A final resort is considering bankruptcy if you cannot afford a consumer proposal.
A licensed insolvency trustee will help you compare all your debt relief options, including debt consolidation, a debt management plan, a consumer proposal, and bankruptcy.
When deciding how to tackle your outstanding debt, it’s crucial to weigh the pros and cons of each option carefully. Consider your current financial situation, including the amount you owe and your ability to make monthly payments.
Use resources like our debt repayment and loan calculator to learn about options to help you pay off your credit card debt. And remember, you don’t have to navigate this journey alone. Our team at Hoyes Michalos will discuss your situation in detail and set you on the path to becoming debt-free.
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Have a Debt Repayment Strategy
Once you’ve secured a loan, a clear debt repayment strategy is crucial to your personal finances and credit.
Before taking out any loan:
- ensure the interest rate is less than that charged on your credit card
- make sure the monthly payments are affordable and fit into your monthly budget
- ensure you thoroughly understand the loan terms included in any loan offer. Review the documents for prepayment options, the loan amount, interest rate, and extra fees.
After signing your loan documents:
- make your loan payments on time to maintain a positive credit score and avoid late fees
- consider setting up automated payments so you don’t accidentally have missed payments
- resist the temptation to run up your credit card balances again.
If you’re looking for ways to effectively pay down all your debt, consider strategies like the debt snowball or debt avalanche method. These approaches to debt repayment can help you prioritize which debts to tackle first, ultimately leading you toward financial freedom and a debt-free future.
