64% borrowers end up seeking more cash after paring their debt
Credit card use has skyrocketed over the last few years. Studies show that the number of middle-income applicants has gone up 78 per cent over the last five years. A closer look at this trend reveals a number of benefits that credit cards have over other forms of credit. Chief among them is the increase in spending power and a sense of security during times of emergency.
On the other hand, personal loans are a more traditional form of credit. People avail personal loans for any number of “personal” reasons. This could be for renovating their home or paying for a much-anticipated summer vacation. However, this trend is slowly seeing a change. With the popularity of credit cards, personal loans are being taken as a means to consolidate credit card debt. There are a number of obvious reasons why borrowers choose to do this. Personal loans demand lower interest rates and give the borrower the option to consolidate multiple payments into one lump sum monthly payment.
But are personal loans really the best way to go when it comes to consolidating credit card debt? Some argue that paying minimum amounts on your credit card may be the smarter way to go. This article looks at the pros and cons of both to help you decide which one is best for you.
Benefits of making minimum credit card payments
It is important to keep in mind that credit cards and loans are fundamentally different. A credit card is a line of credit, and unlike a loan, a line of credit offers considerable flexibility. Although it demands a higher interest rate, borrowers do not have to use it all at once and have the option to pay back either the minimum amount owed or the full amount as they see fit.
Flexibility of repayment
A credit card offers a great degree of flexibility when it comes to making payments. Borrowers who may be going through financial difficulties do not have to make the full payment and can pay a minimum amount instead. This minimum amount is considerably lower than the total amount payable and does not pinch the credit card holder in times of financial difficulty. Once the borrower is in a better financial position, they can clear off their debt when they see fit.
2. Avoid the debt cycle
The debt cycle is a vicious cycle that borrowers generally find challenging to get out of. Taking one loan could invariably lead to taking another if the borrower’s capacity to payback is not met. A study by Credit Union indicates that 64 per cent of borrowers ended up needing more financial help after consolidating their debt. What is worse is taking further loans to get out of debt will levy a higher interest rate on the borrower. Thus, making it more expensive in the long run. Individuals looking for a personal loan should first consider other options like increasing credit card payments or transferring their existing credit card balances.
3. No additional fees
Making regular payments on your credit card will not incur any additional fees as long as the payments are made on time. Personal loans on the other hand incur additional fees like application fees, origination fees, and others.
Benefits of a personal loan
Unlike a credit card, which is a line of credit, a personal loan is a one-time lump sum payment that you have to pay back every month. If your objective is to get out of credit card debt faster, a personal loan is the best way to go. There are a number of additional benefits of a personal loan.
Lower interest rates
Different credit card companies charge varying interest rates. On average, the APR (Annual Percentage Rate) on credit cards is around 20.20 percent. Personal loans on the other hand charge an average interest rate of 9.41 per cent. For individuals with a good credit score, there are a number of low interest-bearing credit options as low as 6.6 per cent. This has a twofold advantage where you can cut CC interest in half all the while becoming debt-free in a shorter span of time.
2. Consolidating multiple payments
This point is true especially if you have multiple credit cards or other debt that you have to repay every month. Keeping track of when and how much to pay every month could be equated to a circus juggling act. Accidentally missing a payment could result in greater interest and late payment charges (which can pinch). And let's not forget a missed payment can impact your credit score pretty negatively.
A personal loan does away with all the hassles of having to make multiple payments. You simply make one payment by a specific date and you are good to go for the remainder of the month.
3. Improve credit score
This is perhaps one of the biggest benefits of applying for a personal loan. Make no mistake, every time you apply for credit, your credit score takes a hit. However, if you have been responsible for your credit in the past, you should count this as a temporary setback. Over time as you pay back your personal loan on time each month, you will see incremental improvements in your credit score. Another important aspect to consider is when you clear off your credit card debt, you will lower your credit utilisation. Credit utilisation is the ratio of credit utilized and the amount of credit available to you. A credit utilisation ratio of 30 per cent or higher will impact your credit score negatively.
Final thoughts
Choosing between making minimum payments on your credit card or taking a personal loan to clear off your debt really comes down to your financial situation. Both options have their pros and cons, it is important for a credit card holder to understand the pros and cons of both options and how it relates to their personal finances.
The author is Co-founder and Managing Director, CredAble
DISCLAIMER: Views expressed are the authors' own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.