We get a lot of emails from people who are really up to their eyeballs in debt. One question we get asked time and time again is, "Should we get a personal loan to pay off our credit cards?" Each situation is different.
The reason why people ask us this question is very simple. On a credit card you are paying 20% plus a year on interest, where on a bank loan you are paying 10% a year interest. The difference while only 10% is huge in dollar terms over a year and it can mean the difference in paying down an amount of debt in a much quicker time. The answer seems pretty easy right; well there are many shades of grey in the answer.
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However there are a couple of questions you should ask yourself. Only when you can answer YES to each question should you think about getting a personal loan to pay off your credit card.
1. Once the credit cards are paid off will I cancel them?
There is no use in paying off your credit cards in full only to start at a zero dollar balance and start racking up debt on them again. Just because you pay down your credit card to zero, the card company doesn't cancel them. You need to request this. We have known people in the past who have done this and continued to use the card like it was someone else's money. Fast forward a year. They now have a portion of the original debt on a personal loan, plus their credit cards are in same debt position they were when they took the loan out. You need to be able to cancel the credit card 100% when the balance has been paid down.
2. Are you comfortable with your home budget?
Are you just scraping by month to month? Or do you need to resort to credit cards to make up the difference. Many people believe if they take out a personal loan to pay off their credit card this will be the answer to their budgeting problems. They take out a personal loan, pay off their credit card, they take our advice and close their credit card. However then tragedy strikes, their fridge breaks down. Due to the fact they are living pay cheque to pay cheque they have no money saved. As quickly as you can say, "I'm doing something that is not very smart" they are back onto any credit card company for a quick approval to get a new plastic card to cover the fridge. Or they are down at the shops taking up an interest free offer on a fridge. Before you take out a personal loan, test yourself. Run through a few scenarios in your mind. What would happen if you needed $1000, $2000 or $3000 quickly? Could you cover it without resorting back to opening a new credit card?
3. Have you got a debit card?
There are some payments in this world where you need a credit card number. Let's face it, over the phone and internet shops, sometimes credit cards are the only way to pay. A debit card allows you to have all the advantages of a credit card but you use your own money. So there is no chance of being charged interest. When closing down your credit card, make sure you have already set up a debit card. Make a list of all the monthly automatic direct debits. You can easily call these companies and get them to change your monthly automatic direct debits to your debit card. You don't want to start getting late fees due to your credit card being closed when companies try to make withdrawals.
4. Can you make additional payments on your personal loan without being penalised?
While credit cards are a financial life-sucking product, they have one good advantage. You can pay more than the minimum payment without getting penalised financially. For example, if you had $20,000 owing and paid off $18,000, there is no penalty for this. Personal loans are not always this cut and dry. There are two different types of personal loans to consider; fixed interest and variable interest.
The big difference is with variable interest you can make additional payments without being penalised (or just a minor fee is charged on the transaction depending on the bank). However with fixed interest, you are agreeing to a set amount of interest over the course of the loan. In fact you could pay out a 5 year fixed interest loan in 6 months and you will still be charged the full five years of interest.
We strongly suggest you take out a variable interest loan. You would have the major advantage of paying additional money to cut the time of the loan, and the total interest you must pay. If you are reading this we would like to think you are extremely keen to get out of debt. And you would be looking to put any additional money to this cause. As your budget becomes healthier over time you should have more and more money to pay off the personal loan. You don't want to be in a situation where you have the money to pay out the loan in full (or a considerable amount; however there is absolutely no financial benefit by doing it.
5. Is the credit card balance too high to pay out in the next six months?
If you owe $20,000 on your credit card, have $500 in the bank and you are living pay cheque to pay cheque, then obviously you will need more than six months to pay back your total debt. However if you only owe an amount, which when carefully looking at your budget you truly believe you could pay out in 6 months, our advice is to forget about the personal loan and concentrate on crushing, killing and destroying your card. With most personal loans you will need to pay an upfront cost, a monthly cost and in some cases, make several trips or phone calls to the bank. All these costs can far outweigh any advantage of getting interest off an amount you are so close to paying back. In this case, just buckle down and get rid of the card.
6. Have you looked at a credit card balance transfer? ***(Very Risky option, only look at this option if you are 100% disciplined)***
If you can look back at point 1 and 2 and you can answer a FIRM YES on both these points, why not call around and look at what a balance transfer could do for you? Some credit card companies will offer you a zero interest balance for up to a year. You can make as many payments as you like with a zero interest balance.
Just some things to ponder here about a balance transfer vs. a personal loan:
1. One great thing about a personal loan is it's not like cash. Once you have used it to pay back your credit card debt, there is nothing else to spend. However with a balance transfer you can get yourself into trouble. For example if you have a $20,000 credit card balance transferred to your new card, the new card might have a $25,000 limit. Credit card companies are smart and they want you to keep on spending and racking up debt. You could easily fall back into old habits. Especially due to the fact, there is a 0% interest rate. Can you not spend one additional cent on the new card while you pay down this transferred balance?
2. Credit card companies like you to pay as little back to them each month as possible. Unlike a bank loan where you dictate how long it will take you to make the loan over (e.g. 1 year to 7 years). Credit cards can stay with you until your funeral if you never pay it off in full. In fact credit card companies in some cases will take as low as 2% of the total outstanding balance as a monthly payment.
To put this into perspective let's compare $20,000 with a credit card @20% interest vs. personal loan over 4 years @ 4% interest.
On a balance of $20,000 on a credit card over one year you would be FORCED to pay $4713
On a balance of $20,000 on a personal loan over one year you would be FORCED to pay
$6087
On a balance of $20,000 on a credit card over four years you would be FORCED to pay $17,770 (This amount would pay down the balance to $17,037)
On a balance of $20,000 on a personal loan over four years you would be FORCED to pay
$24,348 (This amount would pay the balance down to zero)
As you can see, having a personal loan forces you put your money towards your debt. However a credit card almost encourages you to put as little as possible towards it. Most people don't have the discipline to put above and beyond the minimum payments of any debt. You need the discipline of tough nails to take this option.
3. Do you know what happens when the 12 month zero interest free period runs out?
At this point what interest rate will you get? Do they back charge the interest on the remaining debt from the start date? What is the annual fee? Are there any fees for redoing a balance transfer to a different card/company? These are the questions you need to ask before moving your money over on a balance transfer. There's no use doing a balance transfer if you are going to get a ridiculous rate of interest once the honeymoon period is over. You need to know all these things before you do it. The optimal idea is once the honeymoon period comes to a close you do a second balance transfer to a new card with 0% interest.
If you haven't got it by now, please be aware that balance transfers are an extremely risky path to take. We only suggest you do them if you are 100% ready, willing and able to pay back this option in the same time as your personal loan. There are pitfalls all along this path. If for any reason you have some self doubt DO NOT TAKE THIS OPTION. Go back to the personal loan option.
7. Do you know if you can get back your annual fee?
While this question should not influence your ultimate decision to get a personal loan, it is one you should ask. If you pay $100 for an annual fee in January with your credit card and you decide to pay out and close the card in June, some card companies will give you back the remaining annual fee. While the amount in this case might only be $50, it all adds up. However you need to ask for this fee. Some credit card companies in my experience have a nasty habit of forgetting to automatically send you a cheque. You might as well ask the question.
Final Conclusion: As you can see there are many shades of grey when asking this question. You need to sit down and do the sums and come up with the best option for you. If you can answer yes to these seven questions, at least you will have all the information at hand to proceed with the best decision. Please, please, please do not do a balance transfer unless you have all your ducks in place. My advice is for every one person this suits, there are 20 it would not.
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