Killing Credit Cards With A Loan

If you're looking to borrow over several years, then a personal loan is usually a better bet than a credit card.

This article was first sent to Fools as a standalone email in our 'The Good, The Bad and The Ugly' campaign. 

Thanks to a worldwide credit crunch and mounting bad debts, banks and building societies have started to curb their lending. They have withdrawn thousands of mortgages, increased interest rates on personal loans and credit cards, and started to reject far more applications for credit.

I see this as only the beginning of an even harsher clampdown on credit, as lenders tighten up their lending criteria and improve their risk management. Thus, I believe that now is an excellent time for us to wean ourselves off our credit habit. In particular, I think it's high time that we abandoned `plasticmania' -- our addiction to spending on credit cards.

For the record, we have around £55 billion of outstanding debt on our credit cards, which comes to exactly £2,200 per household. However, this is only an average, and millions of credit-card users have far higher balances. Indeed, some visitors to our Dealing with Debt discussion board owe £50,000+ on their plastic. Ouch!

Credit cards are useful for short-term borrowing, especially if you avoid interest by paying them off in full every month. However, because of their high interest rates, they are an expensive way to borrow over periods exceeding a year. (Unless you use a 0% credit card, of course!)

Thus, if you're looking to borrow over several years, then a personal loan is usually a much better bet than a credit card. This is because interest rates on personal loans are considerably lower, as the following example shows:

Swapping a £5,000 credit-card debt for a loan

Let's say that you owe £5,000 on a credit card which charges an interest rate of 1.3% a month, or 16.77% APR. This is close to the average interest rate charged on purchases by a typical credit card. Now let's assume that you decide to pay off this credit card via a monthly direct debit of £153.25 (I've chosen this precise amount for a reason; you'll see why below.)

Here's how much it will cost you to repay this five-grand debt:

So, repaying this debt at £153.25 a month will take you 43 months and cost you £1,548.41 in interest. Now for the alternative: using a Best Buy personal loan to repay this balance:

As you can see, because the interest rate on the personal loan is a great deal lower, your interest bill is far less. Indeed, repaying your credit card with a loan saves you over £1,031 in this case. What's more, you become debt-free in only three years, rather than 43 months. Eureka!

So, in theory, it makes perfect sense to replace expensive credit-card debts with a low-rate personal loan. However, the danger lies in building up additional debts alongside your shiny, new loan. Thus, if you do decide to replace your credit-card debts with a loan, then it's a good idea to cut up your plastic. Otherwise, you could end up even deeper in debt!