Personal Loans v. Credit Cards: Which is Better for Debt Consolidation?
If you’re considering consolidating your credit card debt, you basically have two options: a personal loan or a balance transfer. A personal loan is a loan you take out with a bank. You use it to pay off all your credit cards, and then you pay off the loan over time. A balance transfer is when you move your balances from multiple credit cards onto a single credit card.
But which is better? Personal loans have lower interest rates and a fixed end date for paying off your debt. Balance transfers can offer attractive terms, but there are some things that can be problematic over the long term.
Both strategies have their pros and cons. Here’s an overview.
Personal loans: pros and cons
The biggest pro for consolidating debt with a personal loan? Lower interest rates. Most credit cards can't even come close to the rates offered by personal loan lenders. (For example, as September 2019, Citizens Bank has rates as low as 7.99%. The average credit card charges between 14-20%.) When you're paying off thousands of dollars, a low interest rate is your best friend.
Another pro is that personal loans are “installment” loans—loans you take out once, then pay off over time. Credit cards, on the other hand, are “revolving” debt. You can continually charge more, and there’s no set time to pay it off as long as you make your monthly minimum.
Revolving debt has a bigger negative effect on your credit score than installment debt. So replacing credit card debt with a personal loan may give your credit a boost, usually within a few weeks of consolidating.
But that’s not the only way this method helps your credit score. Replacing credit card debt with a personal loan also improves your credit utilization ratio. That’s the amount of credit card debt you have vs. your credit limit.
Ideally, you want to be using only about 30%—at most—of the credit available to you. But many people use more—and that hurts your credit score. Your utilization ratio accounts for about 30%, or almost one-third, of your entire score. By replacing credit card debt with a personal loan, you can slash your ratio—which is great for your credit.
That said, the personal loan method isn’t for everyone. One thing to consider is that, if you were just making the minimum payment on your credit cards, you may need to extend the loan term of a personal loan in order to get a manageable monthly payment. However, you're still likely to get out of debt faster than you would've if you had continued paying the credit debt. You'll also probably save a bundle in interest charges.
Balance transfers: pros and cons
There’s one major benefit of using a balance transfer to pay off your credit card debt, and that is the 0% APR credit card. But like most things that appear to be "free," it's important to know the terms of the deal.
You’ve probably gotten these in the mail—credit card offers that charge 0% interest for a year. Transferring all your other credit card balances onto the no-interest card is a classic move.
It can be risky, though—because that 0% interest deal is temporary. After a year (or sometimes even less), your interest rate shoots up—and that can wreck your monthly cash flow. Your minimum payment will increase and you'll start racking up interest charges right away. This method is really only advisable if you’re certain you can pay off your debt before your 0% deal expires.
Another thing to consider is that even with 0% APR, that credit card isn’t free. There may be a balance transfer fee—sometimes as high as 5%—among other fees. Be sure to read the fine print before transferring.
Also, not everyone qualifies for 0% APR. If you don’t already have great credit, you may not get much of an interest rate reduction when you switch multiple credit card balances to a single card.
Finally, moving all your debt to one card can impact your credit utilization, which may drive down your credit score.
What's the right option for you?
Both balance transfers and personal loans have pros and cons. Consider how much debt you have, how long you’ll need to pay it off, and your credit score—and hopefully, you should be able to decide on a solution that works for you.
Interested in checking out current rates for debt consolidation loans? Here are our picks for the best deals out there.