A younger cousin recently called me to ask whether he should take a personal loan to clear his credit card dues.
He told me the amount and I was a bit taken aback as he is quite young to be spending that amount. I probed a bit and he confessed that out of boredom, he got a bit carried away during lockdown months and spent recklessly.
This is a common phenomenon.
It’s very easy to overspend on a credit card since as a matter of fact, you don’t see any physical money being spent. Some people wrongly think of credit cards as a second source of income. But a card is not that at all. It’s just a mode of payment and tool for convenience. Nothing more.
That said, its not necessary that people get in credit card debt trap by choice or by reckless spending alone. At times, emergencies and personal situations demand sudden large expenses. And such expenses can also lead to a sudden increase in credit card debt.
But whatever the reason, the fact is that credit card interest rates are exorbitant. More than 40% per annum for most cardholders. And that is what gets people into the debt trap as it is infamously referred to at times. So if for any reason you are unable to pay the full dues, then credit card interest can derail your personal finances.
So what to do when you get yourself into an unmanageable credit card debt situation? There are a number of ways. Like using some existing savings to clear off the dues. Borrowing from family. Or take a personal loan to clear the dues.
Why a loan to clear another loan?
That is, why take a personal loan to clear credit card dues?
It’s actually pretty simple.
The personal loan interest rates are much lower compared to the credit card interest rates.
Credit cards can cost about 40% per annum while depending on the personal loan offers your credit score based profile generates, you can look at paying 12-20% per annum.
Still not cheap if you compare it with other loans like home loan, gold loan and car loan, but nevertheless, much less than credit card rates.
Another aspect is that in personal loans, you have need to pay smaller proportionate monthly EMIs during the loan tenure. In credit cards, you must make the full payment by the next due date to avoid further interest loading*. And that is something which may be difficult for most people if the amount required is high.
*Note – If you are able to repay by the next month’s statement due date, then you will not have to pay any interest on the amount borrowed via credit card. However, if you are unable to pay your credit card bill in full by the due date, it can become a huge problem. You will be charged interest rate from the date of purchase itself. Just paying minimum amount due on credit card won’t help.
So if your credit card bills are too high (compared to your ability to repay it quickly), you can look at taking a personal loan to clear it off quickly and save on a lot of interest.
Let’s take a small example to see how taking a personal loan to clear your credit card dues can work in practice.
Suppose you suddenly have a credit card debt (outstanding) of Rs 4 lac. And your monthly income is Rs 75,000. Now in absence of savings that you can dip into and not considering taking help from family/friends, you cannot possibly clear the outstanding of Rs 4 lac in one go.
Let’s say out of Rs 75,000 income, your monthly expenses are about Rs 50,000. So you have about Rs 25,000 left.
Now let’s see how you can opt for a personal loan.
You know that your monthly repayment (EMI) capacity is Rs 25,000. So you need to take a personal loan of Rs 4 lac which is cleared off as early as possible via a Rs 25,000 monthly EMI.
Assuming you get a loan at 15%, here are the EMIs for Rs 4 lac personal loan for various tenures:
- 1 Year tenure – Rs 36,103 monthly EMI
- 2 Year tenure – Rs 19,395 monthly EMI
- 3 Year tenure – Rs 13,866 monthly EMI
- 4 Year tenure – Rs 11,132 monthly EMI
- 5 Year tenure – Rs 9516 monthly EMI
Since your monthly EMI (upper) capacity is Rs 25,000, you can opt for any tenure that has an EMI less than that. And I know it might seem attractive to opt for longer tenure so that your monthly EMI outgo is low.
But never do that. The longer your loan tenure, the more interest you pay. Have a look at the total interest you pay on Rs 4 lac personal loan during various tenures:
- 1 Year tenure – Rs 33,240
- 2 Year tenure – Rs 65,472
- 3 Year tenure – Rs 99,181
- 4 Year tenure – Rs 1.34 lac
- 5 Year tenure – Rs 1.71 lac
These days, there are several personal loan EMI calculator available online. These calculators not only show the loan EMI but also tell you the total loan interest payable throughout the loan tenure. So I suggest you spend some time on the calculators and play with various options. It will give you a clear picture of the personal loan you can afford and how to go about it.
No doubt the personal loan tenure you choose should be such that the monthly loan EMI should be affordable and comfortable for you to manage during the full tenor and not just initially.
But don’t forget one thing.
Try to chose an EMI that is comfortable for you but not too comfortable Ideally, you should also try to keep the loan tenure as short as possible. So that you can reduce your total interest burden during the loan tenor. Although your EMIs for a short-tenor loan would be higher than a longer-tenure loan, it makes mathematical sense to reduce your total interest outgo.
Here is a bit more about personal loans.
When giving personal loans, the lenders are basically offering unsecured loans without any collateral. So it’s natural that they need to establish your creditworthiness. Right? The lenders measure your repayment capacity based on various factors. Some of the major ones are:
- Credit Score: Your credit score (or CIBIL score) acts as an indicator of your credit history. This score helps the lenders assess how likely it is for you to repay the loan on time. A good credit score can also help you secure a low-interest rate and a higher loan amount as well.
- Monthly Income: Lenders would want to know how much you earn monthly or annually to gauge whether or not you can repay the loan comfortably or not. They would also be interested in knowing how secure is your income and whether its plain salary based on fluctuating business income.
- Debt-to-Income Ratio: The Debt-to-income ratio is a percentage of all your monthly debt payments divided by the gross monthly income. It’s a criteria that lenders use to measure your repaying ability. The higher the ratio, the lesser chances of getting an unsecured loan and vice versa. In general, it’s assumed that 40-50% is the upper limit for this. Beyond that, its understood the borrower will have difficulties repaying the debts on time given his other expenses would also be there.
Many people also use a single personal loan to consolidate their credit card debts across multiple credit cards. This does make things easy.
But let’s not miss the forest for the trees.
If you do find yourself with unmanageable credit card debt, take stock of your credit behaviour. It is very important to not take loans or credit card debt for unnecessary and discretionary things and if you are unable to pay for them immediately. Being reckless about spending just because you have easy access to credit can put you in a debt spiral.
Assuming the expense is genuine, necessary and must be incurred, you need to see which option is best to borrow – Credit Card Vs Personal Loans. The choice would depend on your cashflows, how quickly you need the money and the amount of money you need. In general, a credit card is better for smaller amounts that you can easily repay in a few weeks. But if the amount required is large and you will be unable to pay it soon, then taking a personal loan is better.
One more thing. If you take a personal loan and clear your credit card dues, then 2 things will happen. First is that your personal loan EMI will start. Second is that it will also free up the balance of the card. But that doesn’t mean that you again start spending on your card indiscriminately. Stop using your card for some time till you have your personal loan EMIs.