For consumers, personal loans can bring mixed blessings. A personal loan can help you finance a large purchase or consolidate credit card debt into a single fixed monthly payment.
Many people, when faced with high-interest credit card debt, choose to pay it off with a lower interest personal loan. That could help if you’re facing financial struggles amid the coronavirus pandemic, but it can also create more debt headaches.
A personal loan won’t help if you can’t afford the payment or choose a repayment term so long that it eats into your interest savings. Here’s more about how to tell when taking out a personal loan is a good idea or a bad idea.
How Does a Personal Loan Work?
A personal loan is money you borrow from a lender for just about any purpose and pay back, with interest, in monthly payments over time. Interest rates are fixed or variable, and loan amounts range from about $1,000 to $100,000.
How long repaying a personal loan takes will depend on the lender and the loan term you choose, but many lenders allow you to pay back your loan over one to five years. A longer repayment period lowers your monthly loan payment but increases the interest you will pay compared with a shorter repayment period.
Secured loans such as auto and home loans, on the other hand, require collateral. This is an asset you pledge – examples include a vehicle or home – that the bank can sell to recoup losses if you fail to pay back your debt.
Your creditworthiness, or how likely you are to repay a debt, affects whether you can secure a loan and its interest rate. You’ll need excellent credit to qualify for the lowest interest rates.
“Unsecured personal loan interest rates are primarily based on your credit score,” says Tom Parrish, head of retail lending product management at BMO Harris Bank. “Your interest rate can vary significantly depending on your credit score.”
What Are the Pros and Cons of a Personal Loan?
Personal loans can be good or bad, depending on your financial situation.
A personal loan could help if you:
A personal loan may not work if you:
- Carry a heavy debt load
- Qualify for lower interest rates on home equity loans
- Have a low credit score, which could mean paying a high interest rate
- Prefer to avoid paying an origination fee
What’s the Best Reason to Get a Personal Loan?
Lenders will let you borrow money for almost anything, but you should avoid taking out loans for frivolous reasons. You could use a personal loan to pay for a vacation or even to fund your small business.
But that doesn’t mean you should: A loan could allow you to spend beyond your means and could cause financial harm if you don’t have a plan to pay it off.
Most consumers take out personal loans to make major purchases, to consolidate debt, to pay for home improvements or to cover ongoing expenses, according to a 2020 U.S. News personal loans survey.
For debt consolidation, the fixed rate, term and payment of a personal loans is ideal if you want to pay off high-interest revolving debt, Parrish says.
But if you use a loan for this reason, you will need to put away your credit cards, says Jeffrey Edwards, certified financial planner and president of Atlas Financial Planning in Irvine, California. That way you’re not running up debt while you’re trying to pay it off.
Edwards suggests looking at personal loans as a last resort.
Ask yourself whether you can truly afford the loan and whether the payment will affect other financial goals. That could include saving for retirement, growing your emergency fund or setting aside money for a major purchase, says Angie Furubotten-LaRosee, a certified financial planner with Avea Financial Planning in Richland, Washington.
What Are Signs That a Personal Loan Is a Bad Deal?
If you don’t research your options carefully, you could end up saddled with a high-interest loan bloated with fees.
Here are a few ways to tell if you’re getting a bad deal on your personal loan:
- You have a high interest rate but a good credit score. If you have a strong credit rating, your loan should reflect that with a low interest rate. Start by obtaining preapproval from a lender, along with a rate quote. Once you have a few quotes, you can choose the lender that offers the best terms and formally apply for the loan.
- You are paying a high origination fee. Be mindful of origination fees and how they might factor into the cost to borrow, Parrish says. Compare origination fees, which range from 1% to 6% of the loan amount, and consider overall costs. You could pay a higher annual percentage rate, or APR, in some cases to offset the lack of an origination fee.
- Your loan terms don’t match your needs. Make sure the lender not only provides you with enough money to achieve your goal for the loan but also offers affordable payments.
How Can a Personal Loan Affect Your Credit Score?
A personal loan can help your credit score if you make all of your payments on time but hurt it if you miss payments or default on the loan.
Two of the best ways to quickly improve your credit score – paying down credit card balances and building a positive credit history – can be achieved by paying off a personal loan for debt consolidation. Making payments on time and paying off your personal loan shows you’re a good credit risk, Edwards says.
A personal loan can also add variety to your credit mix, which is a small but important credit scoring factor.
Personal loans could damage your credit score, though, if you fail to make timely payments. This shows lenders that you may be a credit risk.
Borrowers may also worry that loan payments could leave them strapped for cash. Make sure your payment doesn’t stretch your finances too thin.
What Are Alternatives to Personal Loans?
Before you take out a personal loan, make sure you consider some of these alternatives:
Because both types of loans are secured by your home, the interest rates will likely be lower than the rate for a personal loan. But if you have a problem paying the loans, your home could be at risk.
401(k) loan. The coronavirus relief bill relaxed some rules on early withdrawals from retirement accounts. If you borrow against your retirement earnings, you will need to pay back whatever you access, with interest.
This loan has a couple of risks. If you lose your job, you’ll have to pay back the money right away, and the amount you remove will miss out on any stock market gains.
This approach can work if you’re disciplined with your spending.
“If you transfer the balance from a high interest rate to a no interest rate (card) for 12 months, use that opportunity to pay that debt as quickly as possible in that 12 months,” Edwards says.