Back in the pandemic, people were taking advantage of ultra-low interest rates to repay record amounts of non-mortgage debt. This year, however, the Bank of England has raised interest rates in an effort to tame the specter of inflation.
Should borrowers take this opportunity to pay off their credit card debt by taking out a low-interest line of credit for a limited period?
While on the one hand paying lower interest on your debt seems like a good strategy, on the other it means taking on new debt to pay off the old one.
So what should you do? As always, the answer is not an outright “yes” or “no”, but rather “it depends”. Considerations include your own financial situation, the causes of debt accumulation, your ability to repay, and anticipated future income and expenses.
If you decide to consolidate your credit card debt and pay it off with a line of credit, here are some tips on how to approach it:
Think before acting
The logic of moving your debt from a higher interest rate product to a lower interest rate product is sound, but there are some things to keep in mind, says Anne Arbour, financial educator at the Credit Counseling Society, a registered non-profit service for consumers. .
“The most important of these is having and sticking to a disciplined plan to pay off that line of credit without taking on new debt in the meantime,” she says.
“That means not using the excuse of a lower interest rate to add to your line of credit borrowing beyond what you’ve used to pay off your credit card(s).”
To do this in a lasting way, one must understand why the debt arose in the first place. Was the decision to go into debt motivated by a one-time life event? If so, do you have the resources to direct you to the line of credit to clear it permanently within a specific time frame?
If it’s about living beyond your means and then relying on credit to make up the shortfall, “you risk increasing your indebtedness on an ongoing basis,” Arbor says.
Many resources are available to consumers to deepen their understanding and knowledge of their personal and unique financial situation. In the UK, Citizens Advice will give you many options, including information on debt relief orders and repayment plans.
Know and understand all terms and conditions of any product before signing on the dotted line. Ask lots of questions and make sure you understand the answers. Some questions include:
- What is the interest rate?
- What are the monthly payment requirements?
- Is the lowest rate offered continuously or is it only available during a promotional period?
- Are there administration fees?
- What are the late penalties? Are there prepayment penalties?
- What are the terms of the loan?
“All of the answers to these questions could easily negate the benefits of a low-interest product,” Arbor warns.
How should I manage my consolidated payments?
It is important to have a firm plan for paying off the line of credit before committing to it.
“Make sure you stick with this plan throughout, no matter how many flexible payment options you have,” Arbor says, noting that consumers should resist the temptation to treat LOC like a credit card and to make only the minimum payment required each month.
That would mean additional interest and a longer payback period, she adds.
Having a good understanding of your numbers and knowing how much extra you can afford to repay any outstanding amount on a line of credit can save you a lot of time and money.
“Use a budget construction tool and debt calculators can help you create that realistic and achievable plan,” Arbor notes.
Keep an eye on the risks of debt consolidation
One of the main risks is not understanding how the debt accrued in the first place. Was it unusual circumstances or poor financial decisions? Ask yourself the question: “Is debt consolidation a band-aid solution that leaves you vulnerable to accumulating more debt in the future? [and] Are there other options that can help you have a more permanent impact on your financial future? »
Another key risk is not knowing your true ability to make timely and ongoing payments, even at a lower interest rate, which could further damage your creditworthiness.
“There may be better options available to you, such as a debt management program, which can help you make permanent change by consolidating your debts into one monthly payment and negotiating with your creditors. to reduce or completely eliminate interest, so you pay off your principal amount even faster,” argues Arbor.
Borrowers must also weigh the risk of taking out more credit than they actually need. “Many financial institutions will offer a higher credit limit than you might need to pay off all of your existing debt, and that extra, lower rate cushion can be very tempting to use,” she warns.
Establish a repayment period
There are many online debt calculators that can help consumers determine how long it will take them to pay off their debts. Steadfast discipline goes a long way in repaying the loan on time.
“While a fixed loan will have a repayment deadline, most lines of credit are, like a credit card, open and renewable, allowing the consumer to repay and reborrow,” she says. “This is where understanding the terms and conditions of the specific product you are signing up for becomes critical.”
Failure to pay monthly installments by the due date can result in accrued interest, damaged credit rating, and reduced credit rating.
Also, avoid treating a line of credit like an ATM. It can be tempting to access funds when you are going through a weak moment. Once you’ve consolidated your debt, put those credit cards away until at least the debt slate has been cleared.
Don’t be “tempted by the shiny new zero balance on your credit card(s) to start building that debt up again,” Arbor warns.
If you’re still not sure where to start, consult a qualified professional who can help you develop a plan to settle your debt within your financial means.