Denice R. Preston
Personal loans can be used for almost anything. While some lenders might ask you what you intend to do with the money, others want to make sure you can pay it back. Personal loans can be an option for many reasons, even though they are not cheap. This is how you can decide if personal loans are right for your needs.
KEY TAKEAWAYS
- Personal loans are available for nearly any purpose.
- Unlike home mortgages or car loans, personal loans are not usually secured by collateral.
- Personal loans are less expensive than credit cards or other loans but can be more costly than others.
Personal Loans: How They Work
You can get loans that are specifically earmarked for specific purchases. A mortgage can buy a house, an auto loan to purchase a vehicle, or a student loan to pay for college. Your home is the collateral for a mortgage. The collateral for an auto loan is the vehicle you are buying.
Personal loans often lack collateral. The lender will charge you a higher rate for a personal loan because it is secured by collateral that could be taken if you default. Your credit score and your debt-to-income ratio will play a role in determining how high your rate will go.
In certain cases, secured personal loans may also be available. Your bank account, car or other collateral could be used as collateral. Secured personal loans are easier to get and have a lower interest rate than unsecured ones. You can lose your collateral as with any secured loan.
Failure to pay your unsecured personal loan on time can harm your credit score, which could limit your ability to get credit in the future. FICO, responsible for the most popular credit score, states that payment history accounts for 35% of your credit score.
Why Consider a Personal Loan
It would help if you considered other options before taking out a personal loan. There are some acceptable reasons to choose a personal loan:
- You don’t have the right credit score to qualify for a low-interest credit card.
- Your credit card credit limit does not meet your current borrowing needs
- Personal loans are the cheapest option for borrowing.
- No collateral is available.
If you are looking for short-term financing, a personal loan might be an option. Personal loans usually last between 12 and 60 months.
These are just five examples of situations where a personal loan may make sense:
- Consolidating Credit Card Debt
A personal loan could be a good option if you have a large balance on credit cards with high-interest rates. As an example, as of the writing of this article, the average interest rate for a credit card was 19.49%, and the average rate for a personal loan was 9.41%. This difference should allow you to pay down the balance faster and pay less interest overall. It’s also easier to track and pay off one debt obligation than multiple.
A personal loan isn’t your only option. If you are eligible, you may be able to transfer your current balances to a new card with a lower rate of interest. Balance transfer offers may even allow you to waive interest for up to six months.
- Repayment of Other High-Interest Debts
Although a personal loan can be more costly than other loans, it doesn’t have to be the most expensive. A payday loan will likely have a higher interest rate than a personal bank loan. You could also save money if your loan has an older interest rate than what you are eligible for. Be sure to check whether the loan has a prepayment penalty or application fees. These fees can sometimes be quite high.
- Financing for a Home Improvement Project or a Large Purchase
A personal loan can be cheaper than financing through the seller or placing the bill on a card. A home equity loan or a home equity line of credit may be cheaper if you have equity in your home. These are secured debts, so your home will be put on the line.
- Paying for Major Life Events
Finance an expensive event like a bar/bat mitzvah, major milestone anniversary party, or wedding could be cheaper if you use a personal loan instead of a credit card. A survey conducted by Brides and Investopedia in 2021 found that one-fifth of American couples will use loans and investments to pay for their wedding. These events are important, but you may want to consider reducing your debt if it means that you will be in debt for many years. Borrowing money to pay for a vacation is not a good idea unless you are on a life-changing trip.
If you pay all your monthly payments on time, a personal loan can improve your credit score. It will harm your credit score.
- Improving Your Credit Score
If you have a history of missed payments, taking out a personal loan could improve your credit score. A personal loan could be a good option if your credit history is dominated by credit card debt.
However, borrowing money that you don’t need to improve your credit score can be dangerous. It’s better to pay all other bills on time and to try to maintain a low credit usage ratio (the amount you use at any one time relative to the amount you have available).
The Bottom Line
If you have the right circumstances, personal loans may be useful. They are expensive and often offer better options. Investopedia’s loans calculator can help you estimate how much it would cost.
