In an effort to control rising inflation, in mid-September the Federal Reserve implemented a 0.75% hike to its benchmark interest rate. This is the fifth rate hike in 2022, and more increases could be coming before the end of the year.
Higher interest rates affect a wide swath of consumer debt–including credit cards, home, auto, and student loans, and business financing–by making it more expensive to use credit or finance major purchases.
There is good news. If you are thinking about taking out a personal loan to pay down high-interest credit card debt or fund a big purchase, the jump in interest rates won’t affect you quite as much since interest rates for personal loans are established by different criteria than other forms of consumer debt — and many of these factors are under your control.
Learn when taking out a personal loan makes the most sense and when it doesn’t, and how to get the best personal loan as interest rates rise.
When a Personal Loan Makes Sense
Although you can earmark the funds from a personal loan for just about anything you want, there are several scenarios where it makes sense to use the money from a personal loan to reduce high-interest debt.
Credit card vs. personal loan interest
According to the Federal Reserve, the average interest rate for credit cards in the first quarter of 2022 was 15.13%. Even if you don’t have good credit and you open a new credit card account, you’ll likely pay 20% or more in interest on any revolving balances. And even if you don’t access your credit but you have monthly balances remaining on your cards, you’ll soon feel the pain of the Fed’s interest rate hike through a higher annual percentage rate, or APR. As the APR on your cards increases (through no fault of your own), it becomes more expensive to use your cards and pay off balances.
However, if you took out a personal loan with a fixed interest rate that’s lower than the APR on your high-interest credit cards, you could end up saving thousands of dollars in interest payments.
Here’s an example:
- You have a credit card that’s carrying a $5,000 balance, and the card has an 18% APR.
- You can only afford to pay $100 a month.
- It would take you just under eight years to pay off the card balance, and you would pay an additional $4,311 in interest.
In order to pay off the card more quickly and for less money, you take out a personal loan with a 10% fixed interest rate and a fixed payment of $106.26 a month.
- You’ll pay back the loan in 60 payments or five years.
- You’ll pay $1,374 in interest over the term of the loan, a savings of $2,937.
Credit card vs. personal loan total interest
Credit card vs. personal loan payoff
With a personal loan, you’ll also have a clear target date for the final payoff. Paying off your credit card could take even longer than the example above if interest rates continue to climb and bump up your APR.
There are two different types of personal loans: fixed interest rate and variable interest rate.
A fixed rate locks in the interest rate over the length of the loan — it won’t change regardless of federal interest rate hikes, escalating inflation, or other factors. That also means that you’ll have a dependable fixed payment over the life of the loan. A variable-rate personal loan, meanwhile, can reset — either up or down — over the length of the loan. Your loan payments could increase incrementally if there’s upward pressure on interest rates over the length of a variable-rate loan.
Fixed-rate loans, however, provide you with a predictable payment schedule throughout the loan term. One last consideration: variable-rate loans may be lower than fixed-rate loans, at least initially.
When a Personal Loan Doesn’t Make Sense
For some borrowers, taking out a personal loan may not be a fiscally prudent decision. Here are three instances when a personal loan may not make sense.
Low credit score
Borrowers with less than perfect credit may not be able to qualify for personal loans at beneficial interest rates. If the interest rate on your credit card is lower than the rate on a personal loan, swapping debt makes no sense.
When you don’t need it
Don’t take out a personal loan just to purchase something you really want, like a hot tub or a lift kit and new rims for your truck. Avoid taking on more debt in a high-interest rate environment if you plan to use the money for wants instead of needs.
Assuming more debt
If you’ve already dug a financial hole, don’t bring in a backhoe to make the situation worse. Trim the fat by cutting unnecessary expenses, and consider ways to supplement your income to help pay for living expenses and service your existing debt.
Shop for and compare personal loans from the top personal loan lenders.
9 Steps to Get the Best Personal Loan Now
As mentioned earlier, there is a wide range of factors that dictate the terms of personal loans, regardless of the lender. The good news is that borrowers can control many of these factors and maximize their borrowing potential. They include:
Step 1: Know your credit score
Most banks and major credit card providers offer consumers a free credit score and reporting service. A higher credit score typically translates to less risk for lenders and lower interest rates for personal loans.
Step 2: Reduce your overall debt load
Your debt-to-income ratio, or DTI, greatly impacts your ability to get any type of loan. Borrowers with a DTI of 43 percent or higher might be excluded, or offered loans with exceptionally high interest rates.
Step 3: Find a co-signer
While not an option for everyone, having a creditworthy consignor for your personal loan can impact DTI scores and help secure a lower interest rate.
Step 4: Borrow less
Large personal loans bring more risk for lenders, and they typically will offset the increased risk to their capital by charging higher interest rates.
Step 5: Reduce the length of the loan
You’ll save money from interest payments by taking a shorter-term loan. Look for a loan that covers your needs with a payment that falls within your budget.
Step 6: Offer collateral
A secured loan using collateral such as a vehicle or similar asset gives financial recourse to lenders in the event of default, so they likely will offer you better rates and terms.
Step 7: Shop around
Lenders have different qualifying criteria. Creditworthy borrowers should start with banks and credit unions. Online lenders might be the best option for borrowers with less-than-stellar credit, but interest rates are typically much higher.
Step 8: Set up automatic payments
Many lenders will give you a slight discount on the interest rate if you set up autopay for your monthly personal loan payments through your bank.
Step 9: Compare costs
If you qualify through multiple lenders, compare loan origination fees, processing costs, early payoff penalties, and any other administrative fees associated with generating the loan.
Frequently Asked Questions
Here are a few commonly asked questions about personal loans:
What criteria are used to qualify for a personal loan?
To qualify for an unsecured personal loan, lenders look at your credit score, income, and existing debt obligations.
How much can I borrow with a personal loan?
The amount you can borrow largely depends on your credit score and income. Borrowers with poor credit may only qualify for a few thousand dollars, while creditworthy borrowers could take out personal loans for $50,000 or more.
What happens if I pay off the loan early?
Some lenders have early repayment penalties since they are counting on receiving the full amount in interest payments. Make sure you know where your lender stands on early repayment before signing any documentation.
The Bottom Line
Rising interest rates could adversely affect your existing debt. Taking out a personal loan is one way to eliminate high-interest debt. Interest rates for personal loans may tick up as well, but there are still many reasons to consider a personal loan to help manage debt or fund an important purchase.
