In the wake of the recession, America seems to have partially kicked its addiction to credit card debt. According to the Federal Reserve’s quarterly consumer credit report, American consumers have seen a massive net reduction in their holdings of revolving debt, a category comprised almost entirely of outstanding credit card balances. After reaching $1.01 trillion in 2008, the amount of revolving debt has now fallen to roughly $865 billion.
Have Americans resolved to stop spending money they don’t have? Not quite. While this new-found responsibility is at least somewhat attributable to economic uncertainty, it’s worth noting that we’ve also been borrowing more through other channels. Even as revolving debt was falling by $145 billion, nonrevolving debt — that is, loans with fixed terms and amounts — grew by $175 billion over the same period.
And one particular type of loan seems to be on the rise: Personal unsecured loans. Unlike home equity loans, these small loans (some lenders will let you borrow as little as a few thousand dollars) aren’t secured by any of the borrower’s property, and as such are offered mainly to prime borrowers. They also tend to have higher rates, usually in the 10%-20% range depending on your credit score.
How popular are they becoming? Wells Fargo, for instance, says that new originations of personal loans and lines of credit have doubled in the last year. And we’re also seeing more non-bank institutions offering the products.
“In the ’90s personal loans fell out off favor — with the exception of high-rate loans for folks with bad credit — because everyone was pushing credit cards,” says Gerri Detweiler, Credit.com’s personal finance expert. “Now they’re making a comeback, but it’s not so much your bank. The real growth is in lenders who specialize in personal loans.”
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So are personal loans replacing credit cards as the preferred way of borrowing for smaller purchases? If so, that wouldn’t be such a bad thing. After all, a personal loan removes the worst temptation available to cardholders — the ability to pile on more and more debt every month, making only the minimum $15 payment as your balance balloons beyond your control. By contrast, with a personal loan you borrow a set amount of cash and then pay back a fixed amount every month. Instead of digging yourself deeper into debt every month, you’re instead forced to dig yourself out over a set period of time. Another point in their favor is that they tend to have a fixed rate, rather than the variable rate that gets so many credit card users in trouble. And since it’s unsecured, you’re not risking your home if you find yourself unable to pay.
“It’s a loan for a fixed amount of money, for a fixed amount of time and a fixed payment every month, so it’s a great budgeting tool,” says Gail Cunningham, a spokesperson for the National Foundation for Credit Counseling. “There certainly may be people out there who got burned on credit card debt, and they say, ‘I’ve learned my lesson, I’m allergic to plastic.'”
But most people taking out personal loans are doing so not as a credit card alternative, but rather as a credit card panacea. Discover, which has stepped up its marketing of personal loans over the last couple of years, says that it markets the loans primarily as debt consolidation tools — that is, using the loan to pay off the balances on your numerous credit cards, thus transferring all of your debt to a single loan with fixed installments. And consumers seem to be responding: Wells Fargo says the number-one reason given by customers taking out personal loans is debt consolidation, with home improvement coming in second.
So if you’re swamped with credit card debt, is a personal loan a good way to consolidate and get things under control? Yes, with a few big caveats.
The first is that if you make the decision to wipe the credit card slate clean and consolidate into a personal loan, that doesn’t mean that you have free license to start running up new balances on your credit cards. The idea is to give yourself a fresh start and put yourself on a iron-clad plan to get out of debt — not to put your existing debt out of mind so that you can start digging yourself a new hole. Unfortunately, that’s exactly what many people do after consolidating.
[Related Article: 3 Ways a Personal Loan Can Boost Your Credit]
“What we found is that a year later, the person still has their [personal loan] payments but are still running up their credit card balances,” says Cunningham.
The other thing to keep in mind is that the personal loan or debt consolidation plan might not have the best terms. After all, if you’re getting the loan because you’re up to your eyeballs in debt, it’s possible your credit score isn’t so hot. And that means you’re probably getting a rate on the high end of the interest rate spectrum.
You should also be wary of the numerous add-ons that banks and non-bank lenders might try to throw in as a way of increasing the cost of the loan.
“Add-ons could include auto club memberships, a favorite of some small loan companies,” warns Jean Ann Fox, director of financial services for the Consumer Federation of America. “The ‘debt protection’ products sold by banks for both credit cards and loans include credit life insurance, credit accident and sickness insurance, credit involuntary unemployment insurance and credit property insurance.” She points to Capital One, which just got in trouble with the Consumer Financial Protection Bureau for adding unnecessary credit monitoring and purchase protection services to some of its credit cards.
Finally, it’s worth noting that before you go paying off your credit card debt with a personal loan, you might look into getting the final bill reduced. Since not all private companies offering debt settlement are necessarily legit, it’s worth seeing if your issuer is willing to come to an agreement to lower your balance if you’re willing to pay it off right away.
“There are some non-profit counselors that are not affiliated with banks, and I would recommend dealing directly with the bank or credit card issuer to try and work something out with them,” says Ira Rheingold, executive director of the National Association of Consumer Advocates.
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