Do you habitually carry a balance on your credit card? If so, you have chosen one of the most expensive ways possible to borrow money. There are cheaper credit alternatives available.
According to the Federal Reserve's Survey of Consumer Finances, nearly four of every ten American families has an outstanding credit card balance. Credit cards are designed for short-term borrowing and if you are carrying a long-standing balance, you likely are paying too much interest.
You probably know that second mortgages, such as home equity loans or home equity lines of credit, can be cheaper alternatives to using a credit card. However, not everybody owns a home or has sufficient equity to borrow against. For those who are not in a position to obtain a mortgage, a personal loan can be a cost-effective alternative to carrying a credit card balance.
Interest Rate Trends
The numbers make a compelling case. According to the Federal Reserve, the average interest rate charged on credit cards is 12.89 percent, while the average rate on a two-year personal loan is 10.22 percent. That can make personal loans a cheaper form of credit by 2.67 percent.
The rate advantage for personal loans widened last year. During 2013, the average rate charged on credit card balances rose by eight basis points (8/100ths of one percent), while the average rate on personal loans fell by 42 basis points. Those moves in opposite directions can make personal loans even more attractive as alternatives to carrying credit card balances.
Good Uses for Personal Loans
When should you consider a personal loan? Here are three examples:
- Long-term purchases. Many of the items you buy for your home, such as electronics or furniture, carry a big upfront cost, but have a long useful life, so they don't have to be replaced anytime soon. For these items, borrowing the money for the purchase and paying off the debt before the purchase needs replacement would be a more cost-effective approach than simply charging the item to your credit card and paying the balance down gradually.
- Filling temporary gaps. Sometimes, people face temporary periods waiting for income to be restored or for other sources of funding to be delivered -- for example, if you are on temporary medical leave or waiting for an estate to settle. If you know you have a reliable source of funds coming to repay the loan, a personal loan can be a good way to make your way through these temporary financial gaps.
- Debt consolidation. If you are carrying credit card balances that you are not in a position to pay off right away, you can simplify your finances and reduce your interest expense by taking out a personal loan to zero out higher interest debt.
Managing Debt Responsibly
Like most financial tools, personal loans are a resource that can be very helpful if used responsibly. It is important to avoid adding a loan obligation that you will be unable to meet. Here are three keys to managing debt responsibly:
- Don't take on long-term debt for short-term spending. If a loan takes longer to repay than the useful life of the item being financed, you are setting yourself up to accumulate debt faster than you can repay it -- for example, if you take on a five-year loan to buy a laptop that you need to replace in three years, you'll still be paying on the loan for the old laptop, plus a new loan for the next machine.
- Budget before you borrow. Don't wing it -- before you borrow, look at your payment schedule and do a trial run to see if the payments fit within your household budget.
- Shop for competitive rates. Personal loan rates are generally cheaper than credit card rates, but not all loan rates are the same. Obtain personal loan quotes from different lenders to make sure you are receiving the lowest rate possible.
While 39.4 percent of American families have credit card debt, only 11.5 percent of them take advantage of installment loans other than vehicle or student loans. This differential suggests that personal loans are an underutilized resource and that millions of families are paying too much to borrow as a result.