Personal Loans: The Basics
Personal loans are quite popular these days. They range from amounts as small as a couple of thousand dollars, to over $50,000 (depending on one’s income), and carry interest rates from as low as 5 or 6%, to over 20% (which is in the same range as high-interest credit cards).
Such loans typically carry a repayment period of 2 to 5 years. These loans are often used to pay down credit card debt.
Let’s say that you are carrying large balances on several credit cards (maybe over 50% of your card limit), and paying high interest rates (perhaps over 20%). Once you are approved for a personal loan, the lender will deposit the funds in your bank account.
You can use the personal loan to pay off your credit cards. Then, over the next several years, you will pay down the personal loan.
What sort of FICO score do you need to qualify for a personal loan? While credit score requirements can vary, most lenders require a score of at least 640, especially if you want to qualify at competitive rates and terms (i.e. a lower interest rate than your credit cards).
Using Personal Loans To Pay Down Credit Card Debt
Once the money is deposited in your bank account, you can simply login to each credit card, and pay off the balance. By doing so, you’ll no longer be paying large amounts of interest on each card. The money you save can be put to a variety of good uses, whether that be saving towards the down payment for a home, or building wealth through investing.
What about your credit score? 30% of your FICO score is decided by how much debt you carry. Revolving debt (i.e. credit card debt), often playing an even larger role than installment debt (i.e. personal, auto, mortgage and student loans), in deciding your credit score.
Ideally, you’ll want to keep your revolving debt amounts below 30% of your credit card limit, for each account and across all accounts in total. So, if you have 3 credit cards, each with a $1000.00 limit, you’ll want to have a balance of $300.00 or less on each card, and a balance of less than $900.00 in total.
High balances greatly reduce your credit scores. Even if you are slightly past 30% of your limit, you are likely to lose points on your credit score, with balances over 50% having an increasingly large negative impact. Excessive credit card balances can reduce your score by more than 100 points.
This leads to you overpaying, when you apply for a mortgage, auto loan, or even home or auto insurance. Signing up for a personal loan which allows you to reduce credit card debt, can thus make a lot of sense.
Clearly, personal loans offer significant benefits, in terms of both savings and credit scores. Yet, how do you know whether a particular loan is a good fit for your specific situation?
First, look at the total amount of interest you are paying across each of your credit cards, each month. To do this, you can login to the online platform for each credit card, and look at the interest rate listed.
Calculate your average credit card interest rate, across all of your credit cards. You can do this by adding up the interest rates on your various credit cards, and dividing by the number of credit cards you have.
If you are able to find a personal loan with an interest rate that is significantly lower than your average credit card rate, you likely have a good deal in hand. You won’t know your exact interest rate until you are approved for a loan, but before you do so, you’ll have a good idea of which deals are likely to be the most competitive.
If the interest rate on a personal loan is as high or higher than your credit card debts, then it’s probably not worth your time. Remember, you’re using the personal loan only to pay down cards – not to fund other expenses.
Shopping For A Personal Loan
Shopping for personal loans is easier than ever. Online platforms like Credit Karma, Nerdwallet or Bankrate display offers from various lenders, and allow you to submit applications. In most cases, these websites allow you to find out whether you’ll be preapproved before you actually apply for the loan, though you should confirm this.
Keep in mind that these platforms are compensated if you sign up for a loan through their website. This doesn’t mean their recommendations aren’t good – they often are. However, you should be aware of why they might be suggesting something.
Being aware of your chances of approval (and the interest rate), before applying helps you avoid an unnecessary credit inquiry, which can reduce your credit score. After all, the goal is to improve your score (and save money) not make things more difficult.
You could also apply for credit directly with the personal lender. Companies like Upstart, Avant, Best Egg, Marcus and Prosper are all good options. However, there is definitely some degree of convenience in shopping centrally through Credit Karma or Nerdwallet.
Repaying Your Personal Loan
As we’ve discussed many times, it is very important that you pay all of your credit obligations on time every month. Remember, your payment history accounts for 35% of your FICO score (the largest factor in deciding your score).
You can ensure this happens by setting up autopay, so that you never have to remember to make a payment. Another option is to put your payment due date on your calendar, to ensure that you never forget.
Still, you should log in to your account at least once per month, just to make sure that everything looks normal. Mistakes can happen, and you don’t want your credit to be damaged as a result.
The Final Word
Credit card debt is very costly, both in terms of it’s impact on your FICO score, as well as the high interest rates, and money you end up wasting. For this reason, reducing credit card debt is always a good option.
Personal loans offer an excellent, simplified approach to reducing credit card debt, and saving money. While they aren’t a great option for someone with poor credit (since personal lenders typically want at least a decent credit score), they do make sense for those who pay bills on time, but have too much credit card debt.
