Getting out of debt, particularly consumer debt, is the cornerstone of financial freedom. It frees up cash for saving and investing. It enables us to get off the treadmill of living month-to-month. And being debt-free just feels great.
A lot has been written on how to get out of debt. It’s not exactly rocket science. Almost all advice on this subject can be boiled down to three things: 1) stop going into more debt; 2) pay off high interest debt first; and 3) put as much toward your debt as you reasonably can. To be sure, there is some debate here. Some argue you should pay off small loans first as a way to stay motivated. But the basic approach to getting out of debt remains the same.
There is one debt payoff tool, however, that is often overlooked—personal loans. It may seem odd to use new debt to get out of old debt. Indeed, there are some risks to this approach. If used correctly, however, personal loans can lower your interest payments and shorten the time it takes to become debt-free.
Here are five things to consider before using a loan to pay off existing debt.
1. Interest Rates
Refinancing existing debt to lower the interest rate is the closest thing to a free lunch in the world of personal finance. A lower interest rate reduces the amount of interest paid and, assuming the term of the loan is the same, also reduces the monthly minimum payment. Refinancing existing debt with a lower-rate personal loan is a smart way to accelerate debt repayment.
2. Term of the Loan
Care must be taken to make sure the term of a personal loan is consistent with your budget and goals. If a personal loan has a shorter term than existing debt, monthly payments may be more than your monthly budget can support. At the same time, greatly extending the term of a loan can result in more interest paid over time.
The key to using personal loans as a tool to getting out of debt is achieving lower interest rates (as noted above). While this can include consolidating multiple debts into a single new loan, consolidation by itself is not beneficial. It may reduce the number of monthly payments that must be made, but if the new loan comes with a higher interest rate, the added convenience may not be worth the cost.
Personal loans are typically unsecured debt. In some cases, however, lower interest rates can be obtained through secured loans, such as a home equity line of credit. While this is a reasonable option in some cases, it’s important to understand that failure to pay a home equity line of credit could result in the foreclosure of your home.
5. Where to Start
For those considering a personal loan, there are several options to consider. First, a 0% balance transfer credit card offers arguably the best terms available. There typically is a balance transfer fee of 3%, but the best balance transfer cards today offer the 0% terms for up to 18 months.
When it comes to getting a personal loan, having a higher credit score will get you access to lower interest rates. Before you apply for a personal loan, it can help you to know where you stand, credit-wise, so you can look for the best rates within your credit range. You can see your credit scores for free, updated every 14 days, on Credit.com.
More on Managing Debt:
- How to Pay Off Credit Card Debt
- 5 Tips for Consolidating Credit Card Debt
- The Best Way to Loan Money to Friends & Family