Why it’s not always cost efficient to use personal loan to clear credit card debt
The subject matter has become a common scenario among credit card debtors. Taking a personal loan to settle credit card sales method has also been adopted by banks in pushing their personal loan product. But is that wise? Key question – is the total sum paid to settle the personal loan actually less than the sum which would otherwise be paid to settle the credit card debts?
For that, a few factors need to considered. Firstly, the tenor; while credit cards have an indefinite tenor with a minimum of 5% of outstanding balance to be paid, a personal loan offers a range of between 1-7 years for repayment. This sounds better. Secondly, and more importantly, what is the actual annual interest rate of the personal loan (which differs from the nominal fixed rate quoted for personal loan) as compared to the annual interest rate of the credit card, which is about 18%?
The nominal fixed interest rate that are usually quoted for personal loans (which ranges from 7.5% to 12%) is not an apple to apple comparison to the 18% annual interest rate charged for credit card debts. So, you’re dead wrong if you assume that a 12% nominal fixed interest rate for personal loan is better than a 18% per annum credit card interest rate.
To get a better understanding of the two types of interest rates, let’s look at their difference. Nominal fixed interest rate is similar to a hire purchase interest rate, whereby a fixed rate is charged against principal, and levied over the period of the payment. There is no consideration given towards the reducing principal balance as the repayments take place. Whereas, the credit card annual interest rate is a reducing balance interest charge, therefore interest is charged monthly on the reduced principal balance. This is similar to a housing loan interest calculation.
Let us now look at some examples of interest calculations whereby we derive the similar annual interest rate for the personal loan so that we can compare apple to apple with the credit card annual interest rate. The following assumptions have been adopted:
* Personal loan sum: RM10,000
* Repayment period: 3 years on 36 equal monthly instalments
* Nominal fixed interest rates (NFIR): 8%, 9%, 10%, 11% and 12%
For the different NFIRs, I have come up with a schedule (Table 1) to show the monthly and annual interest rates for the personal loan.What Table 1 shows is that for a given NFIR, there is a substantially higher annual interest rate. The 18% annual interest rate for credit cards sits between the 10% and 11% NFIRs. With some banks now reducing the credit card annual interest rates to 16%, the equivalent for personal loan sits between the 8% and 9% NFIR.
Let us now try different tenors for the loan repayment compared to the fixed 3 years and see the difference in the annual interest rates as per Table 2.
Therefore, annual interest rates are lower with longer tenors, but do bear in mind that longer tenors will entail bigger absolute sum being payable.
Another issue that is equally important but which is usually disregarded by borrowers is the fact that the personal loan is not paid net, but comes after deducting the cost of processing and handling fees. The fee usually comprises a fixed and a percentage rate. Going back again to our RM10,000 personal loan, let us assume that we only get paid RM9,650 after deducting RM350 for fees, how does this affect the annual interest rate? Refer to Table 3.
You will note that the annual interest rate has increased about 2.6% with the introduction of loan processing fees.
Now, let us go back to our main question – if I have a credit card debt that carries an annual interest rate of 18%, do I take a lower NFIR rate personal loan to settle it? The answer is ONLY if the personal loan offers a NFIR of lower than 8.53% (recomputed to 2 decimals based on assumptions in Table 3)
Having said that, for anyone considering converting credit card debts, the better option would be to do a transfer balance, whereby another bank undertakes to settle the credit card balance on your behalf and sets up a reducing balance loan account, albeit certain conditions of course.
Be an informed borrower; ask your banker for annualised interest rates or effective interest rates of any loan product. If the banker uses bombastic words, try making reference to hire purchase and home loans, whereby you understand how these interest mechanisms work.
Source : The Star