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Is an unsecured personal loan the best way to consolidate debt?

Susan Keating

Dear Credit Smart,
I am $20,000 in credit card debt. I am making minimum payments, and thinking about applying for an unsecured personal loan to take care of higher-interest credit cards instead of another credit card. What would you recommend? – Dorothy

Dear Dorothy,
Although you didn’t tell me what the interest rates are on your cards, I used the minimum payment calculator at CreditCards.com to get an idea of your situation. Assuming the average interest rate of 15.5 percent and the industry-standard minimum payment (all monthly interst plus 1 percent of the balance), today you are paying about $460 a month.

At that rate, you are looking at 355 months – almost 30 years – to pay off this debt. In that time, interest payments will be about $24,948.70 – as much as 125 percent of your debt today. So I applaud your desire to attack this debt more aggressively, especially since it could well be that you have a higher interest rate than the one I used in this example. 

An unsecured personal loan, which enables consumers to replace their minimum and variable card payments with fixed loan installments, might be a good option for you – if you can qualify for a low rate. While many companies may advertise rates as low as 5 percent, you generally must have excellent credit to qualify. Assuming you can qualify for this rate, you could be looking at payments of about $500 for 44 months, which means your monthly payments would increase by about $40, but you would pay off your debt 26 years earlier compared to the above scenario. You just need to be sure you are getting a rate that will benefit you in the long run.

You also mentioned the option to use another credit card, I assume via balance transfer. If you can qualify, this could be a great option, because there are still cards offering 0 percent interest for balance transfers. Zero percent interest doesn’t mean this alternative is free, because there almost always will be a balance transfer fee (often around 3 percent of the amount transferred), but it could save you quite a bit of money. You do need to know that 0 percent interest offers are generally for a set amount of time, which may not be long enough to pay off the whole balance before the rate expires. In addition, just like an unsecured loan, in order to qualify for the best rates you must generally have very-good-to-excellent credit scores. Look for a card with low transfer fees and longer terms if you decide to try this route, and don’t forget to check on what the rate could be once the 0-interest period passes.

A bit of DIY – and discipline
Another option for you is to do it yourself. As I said earlier, your minimum payment today is about $460. The way minimum payments work, if you make no additional charges, your payment will go down each month by about $5. The calculation shown above takes those payment reductions into account. However, if you can commit to paying the same $460 every month, you can pay this debt off yourself in 65 months, or about 5.5 years. The interest you would pay in that time would be about $9,556.58 – a savings of $15,392.12 compared to your current option. While it is likely more than you would pay in interest with an unsecured loan, you would not have to worry about qualifying because you already have the cards. This approach does take discipline on your part.

Whatever option you choose, you must look at ways to reduce your dependence on credit. It is easy to fall into the same trap if you cannot do that. Take a hard look at your monthly spending, and see if you can find areas to reduce or even eliminate to free up additional funds for debt repayment. Consider a garage sale or a second job to generate extra funds that you can put toward your debt. To protect your credit and for convenience, you may want to keep a credit card open. Paying your balances in full each month is the very best way to use credit to your advantage, but sometimes that is not possible. Try to use credit only for purchases that you know you can afford to pay off in a reasonable amount of time.

Remember to always use your credit smarts!

See related: Staying on track after getting a debt consolidation loan