Should you take out one loan to pay off another?
Taking out a personal loan to pay off a card or loan can provide great benefits for your finances, including saving interest on your debt payments, consolidating several debts into one and simplifying the management of your finances.
But, as always, there are some considerations to take into account before accepting a loan to change or consolidate your debt, which can help you know if it really suits you or not. And here’s the list.
When NOT to ask for a loan to pay debts?
1. When the rates you are charged are high
Getting a loan to pay off a debt should help you save. So, if you are being offered a loan for this with rates higher or almost the same as those you are currently paying, it is not a good idea to accept it.
So, before accepting any loan, carefully review the interest rate you will have to pay and other details in the contract, such as the commissions charged. Make comparisons with respect to similar products from other financial institutions, so you can choose the loan that best suits you.
Paying off one loan with another is only worthwhile if the costs of the second loan are lower than the first. Otherwise, you will only be able to fill a financial hole by generating another one.
2.- When it represents an expense greater than your income
You must be clear that, if you are thinking of taking out a loan to pay debts, this should not represent an additional effort for your finances, since it should help you save interest. Many times, it can even mean a decrease in your monthly payments.
It is not appropriate for you to accept additional credit if this implies such a strong pressure on your finances that it will end up taking away your savings and leaving your pockets empty. Instead, prioritize strategies to generate additional income or increase your savings.
3.- When you can pay off your debt without the need for credit
If your current debt can be paid off with your income and savings, use them instead of taking out another loan. It makes no sense to get into debt if you don’t have the need to do so.
If your finances are healthy and you have the capacity to pay, it is better to apply for loans for other medium and long term needs, such as buying a car with a low interest rate or a mortgage, which will also increase your Credit Bureau Score because you will demonstrate your capacity to correctly manage different financial products.
When should you apply for a loan to pay debts?
1.- When the interest rate is lower than the current interest rate
Borrowing money to pay another loan is an advantage, as long as you know how to manage your accounts without arrears. If you are a good financial user, you can opt for loans that offer lower interest rates, with accessible terms and payments and few extra fees.
There are financial institutions that use technology, called fintech, that offer loans at lower costs than banks and are willing to support you if you have a good credit score. It’s advantageous to apply for loan at these platforms and get better conditions to get out of debt.
2.- When you are looking to consolidate debt
When you have several active debts from different loans or cards, the best thing to do is to request a consolidation, which consists of joining several debts into one, paying a lower interest rate than the one charged by banks.
Changing your debt is a great alternative because it will allow you to save up to half of the interest and concentrate your efforts on paying only one debt. It is also a strategy to keep control of your finances without the risk of running out of resources.
3.- When you can pay down principal at no additional cost
Some financial institutions charge penalties for prepayments or principal payments. Accepting these loans is disadvantageous for you, so you should always look for companies that allow you to do so without any problem.
Prepaying and paying down principal helps you save even more interest, so if you have the ability to prepay your debt, don’t hesitate to use this to your advantage.
Here are some tips
1.- Avoid using your cards to the limit. Unnecessary and excessive expenses are usually the source of the debt we get when we ask for another credit to pay for a previous one.
2.- Avoid going further into debt while you pay off the consolidation credit. For example, try not to use your card and do not ask for more credit.
3.- Plan and define amounts to pay your debts. Set aside specific amounts for your cards, and always remember the payment deadlines so that you are not surprised by interest or late payment charges.
4.- Learn to use your credit cards correctly. Use them to take advantage of offers, such as furniture or long-lasting appliances at interest-free months, and do not use them as if they were an extension of your salary.
5.- Do not use cash on your credit card. Banks will charge you additional interest and commissions for this. So the money will be more expensive than you think.
I am Nikesh Mehta, owner and writer of this site.
I’m an analytics and digital marketing professional and also love writing on finance and technology industry during my spare time. I’ve done online course in Financial Markets and Investment Strategy from Indian School of Business. I can be reached at [email protected] or LinkedIn profile.