by Matt Frankel, CFP | Dec. 2, 2018
The personal lending industry has exploded over the past few years. It used to be rather difficult for many Americans to obtain a personal loan -- you had to go to a bank, you may have needed to pledge some assets as collateral, and the paperwork process could be exhausting.
In recent years, many companies, both new and pre-existing, have begun offering innovative and streamlined personal loan products, and millions of Americans have taken advantage. If you’ve been wondering if a personal loan is right for you, here are three reasons you may want to take a closer look at the offers available to you.
One of the top reasons people consider personal loans is to save on interest. The average credit card APR is currently about 16%, and many people are paying much higher rates than that. If a personal loan is available with a significantly lower APR, it could save the borrower lots of money.
Here’s an example. Let’s say that you owe $20,000 across a bunch of credit cards and you’re paying an average APR of 18%. If you commit to paying your debt off over a four-year period, you’ll need to pay $587 per month and will end up paying $8,200 in total interest.
On the other hand, if you can obtain a personal loan at 12% interest, a four-year repayment schedule would translate to a monthly payment of $526 and total interest of $5,280 -- saving you nearly $3,000.
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Here’s one important thing to keep in mind as you start the process of shopping for a personal loan: Interest rates can vary dramatically among lenders -- even the rates offered to the same borrower. A recent LendingTree report found that the difference between the highest and lowest interest rates the typical borrower is offered by personal lenders vary by a staggering 879 basis points (8.79%). That’s a big difference, so it’s definitely worthwhile to take your time and shop around.
One of my favorite things about personal loans from a financial planner’s perspective is that they force the borrower to commit to a much more aggressive repayment schedule than a credit card typically will.
In other words, if you obtain a personal loan, you’ll probably commit to repaying it in equal installments over a period of say, three, four, or five years. On the other hand, credit card minimum payments can be minuscule and can allow you to stretch your debt over a much longer time period.
If you have a habit of just making your credit card’s minimum payment, a personal loan could help force you to accelerate your debt repayment by eliminating the low-payment option.
In my opinion, this is perhaps the best reason to consider a personal loan to pay off your credit card debt.
The second-largest category used to determine your FICO® Score is “amounts owed,” which makes up 30% of your score. Rather than the dollar amount of your debt, this category considers things like the amount of credit card debt you have relative to your credit limits and the amount you still owe on installment loans relative to their original balances.
One important point to keep in mind is that not all types of debt are considered equally in the formula. Specifically, credit card debt is generally considered to be a much more negative factor than installment debt -- especially if you have relatively high credit card balances relative to your credit limits.
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Therefore, obtaining a personal loan to consolidate your credit card balances can have the effect of boosting your FICO® Score by a significant amount.
As a personal example, in the process of buying and furnishing our current home a few years ago, my wife and I built up quite a bit of credit card debt. It wasn’t too excessive, but it was about 25% of my total credit limits at the time and was certainly weighing on my FICO® Score.
I obtained a personal loan shortly after and used it to pay off all of my credit cards, except for a small balance that was on a 0% introductory APR. After the new loan appeared on my credit report and the credit card balances gradually updated to $0, my FICO® Score jumped by a very-significant 40 points. The amount of debt I had didn’t change -- merely changing the type of debt I had provided a tremendous boost to my credit score.
To be perfectly clear, there are certainly some reasons why a personal loan might not be better than your credit card debt. For example, if you have credit card debt on a card with a 0% promotional APR and you’re confident you can pay it off before the promotional period ends, it could be a smart idea just to leave it where it is.
Having said that, there are some great reasons you might want to consider a personal loan, and if any (or all) of them apply to you, it could be a smart financial move to shop around and examine your personal loan options.
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