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When are personal loans a good idea?
They can be expensive However, they’re usually the most effective option.
By Tim Parker
Updated November 12, 2021
Reviewed by Janet Berry-Johnson
A personal loan can be used for just about anything. Some lenders will ask what you’re planning for the money however, others want to be sure that you have the ability to pay back the loan. Although personal loans aren’t inexpensive, they can be an option that is feasible for a wide range of situations. Find out which one is best for you.
Important Takeaways
Personal loans can be used to fulfill almost any need.
Unlike home mortgages and car loans however, personal loans generally aren’t secured by collateral.
Personal loans are often less costly than credit cards, and other kinds of loans but more expensive than others.
How Personal Loans Work
Some kinds of loans are earmarked for a specific purchase. It is possible to purchase a home using a mortgage, buy a car using an auto loan or pay for college with an undergraduate loan. When you take out a mortgage, your house is used as collateral. Similar to an auto loan the vehicle you purchase will serve as the collateral.
However, a personal loan typically does not have collateral. Because it is unsecured by property that the lender may seize should you default on the loan, the lender takes on a greater risk and will likely charge you a higher interest rate than it would with a mortgage or car loan. Just how high your rate will be is contingent on a variety of variables, including your credit score as well as your debt-to-income ratio.1
Personal Factors affecting the Interest Rate of a Loan
Investopedia / Lara Antal
Secured personal loans are available in certain cases. The collateral could be your bank account, your car, or other property. Secured personal loan might be easier to obtain and has an interest rate that is lower than an unsecure one. Like any other secured loan the risk of losing the collateral you have secured if you are not able to make the payments.
However, even with a personal loan Of course failure to pay on time payments could harm your credit score and severely hinder your ability to get credit in the future. FICO is the company that created the most widely used credit score, claims that your history of payments is the primary aspect in its formula, accounting for around 35 percent of the credit score.2
If you are considering a personal Loan
Before you opt for an individual loan it is important to consider whether there may be alternatives that are less costly to take out the loan. The most acceptable reasons to consider the personal loan are:
There is no way to be eligible for a low-interest credit card.
The credit limits of your credit cards aren’t sufficient to meet your current borrowing needs.
Personal loan is the least expensive borrowing option.
There is no collateral to provide.
You may also think about an individual loan when you’re looking to borrow for a limited and defined amount of time. Personal loans generally range from 12 to 60 months.3 For instance when you have a lump sum of money due in two years , but don’t have enough cash flow during that time A two-year personal loan might be an option to fill in the gap.
Here, for example, are five scenarios where a personal loan might make sense.
1. Consolidating Credit Card Debt
If you owe a substantial balance on one or more credit cards with higher interest, getting an individual loan to pay off the debt could save you money. For instance, as of this writing, the median interest rate for a credit card is 19.49 percent, whereas the average rate on personal loan is 9.41%.1 The difference in rates should enable you to pay off the debt more quickly and pay less interest overall. Plus, it’s easier to keep track of and pay off a single debt rather than multiple ones.
But the personal loan is not the only choice. Instead, you might be able to transfer your balances to a different credit card with lower rates of interest, if you qualify. Some balance transfer offers even eliminate interest during an extended period of promotion of at least six months.
2. Repaying other high-interest debts
While a individual loan is more costly than other kinds of loans but it’s not the most expensive. If you have a payday loan, for example, it is likely to carry a far higher interest rate than an individual loan from banks. Similarly, if you have an older personal loan that has a higher interest rate than you would qualify to receive today, replacing it with the new loan can save you cash. However, before you make the switch ensure you find out whether there is a penalty for prepayment for the previous loan or application or origination fees on the new one. These fees could be significant.
3. The financing of a home Improvement or major Purchase
If you’re purchasing new appliances, installing a brand new furnace, or are making another important purchase, getting a personal loan could be cheaper than financing with a seller or putting the bill on a credit card. However, if you have any equity that has been built up within your house, then a home equity loan or home equity line of credit may be less expensive still. Of course, they are both secured and you’ll be putting your home in danger.
4. Making a payment for the cost of Major Life Event
Similar to any big purchase, financing a costly occasion, like a bar or bat mitzvah or a significant anniversary celebration or wedding could be less expensive If you can pay for the occasion using a personal loan instead of credit cards. According to a survey in 2021 conducted by Brides and Investopedia, one out of five U.S. couples will use loans or investments to to pay for their wedding. However important these occasions are, you could consider reducing the amount slightly if you’re going in debt for years to come. For that same reason, borrowing money to finance a trip might not be the best idea, unless it’s the holiday of the lifetime.4
A personal loan will help you improve your credit score, if you pay every payment on time. Otherwise, it will hurt your score.
5. Improve Your Credit Score
Taking out a personal loan and paying it off on time can increase your score on credit, especially in the event that you’ve had a history of missed payments on other loans. If your credit report shows mostly loans from credit card companies, obtaining a personal loan can also boost the “credit mix.” A variety of loans and proving that you are able to manage them in a responsible manner is considered to be a positive for your score.5
But, taking out a loan for funds you don’t really need in the hope of improving you credit standing is a risky proposition. Better to keep paying your others bills promptly, while also trying to maintain the lowest percent of your credit’s utilization (the amount of credit you are making use of at any time as compared to the credit you have accessible to you).
The Bottom Line
Personal loans can be beneficial in the right circumstances. They’re expensive, and there are often better options. If you’re thinking about one, the Investopedia personal loan calculator can help you determine what it will cost you.
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