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When Are Personal Loans a Good Idea?

They can be expensive However, they’re usually your best 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 doing with your money, but others will just need to know if you’re able to pay it back. Though personal loans aren’t cheap but they are an option for you in many different situations. Here’s how to decide which one is best for you.

The most important takeaways

Personal loans are a great option for almost any purpose.

Contrary to car loans Personal loans are usually not secured with collateral.

Personal loans may be cheaper than credit cards, and other types of loans however they are more costly than other types of loans.

How do personal loans work?

Some kinds of loans are specifically arranged to be used for specific purchases. You can buy a home using a mortgage, buy the car you want with an auto loan, and take out a student loan. With mortgages, your home acts as collateral. Similarly, with an auto loan the vehicle you purchase will serve as the collateral.

However, a personal loan often has no collateral. Since it’s secured by the property which the lender can seize in case you default on the loan, the lender takes on a greater risk and will likely charge you a higher rate of interest than with a car or mortgage loan. How high the rate will be can depend on a number of factors that include your credit score and debt-to-income ratio.1

Personal Credit Interest Rate Factors

Investopedia / Lara Antal

Personal secured loans are also possible in certain instances. The collateral could be your car, bank account, or other property. The secured personal loan might be easier to obtain and has a somewhat lower interest rate than an unsecured one. Like any other secured loan, you may lose your collateral if you are not able to make the repayments.

However, even with a personal loan Of course the inability to make timely payments can be harmful to your credit score and severely hinder your ability to get credits in the future. FICO the company behind the most widely used credit score, says that your payment history is the primary aspect in its formula, accounting for around 35 percent in your credit score.2

When to Consider a Personal Loan

Before you decide to take out a personal loan you should look at cheaper ways to borrow. The most acceptable reasons to consider the personal loan are:

You don’t need and can’t be eligible for a credit card.

The credit limits of your credit cards don’t meet your current borrowing needs.

Personal loan is the least expensive borrowing option.

There is no collateral to offer.

You might also consider the possibility of a personal 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 So, for example when you have an unpaid amount due in two years , but don’t have enough cash flow in the meantime, a two-year personal loan might be an option to fill in the gap.

Here, for instance, are five circumstances when a personal loan could be a good idea.

1. Consolidating Credit Card Debt

If you owe a substantial amount due to one or several credit cards with very high rates of interest, taking out a personal loan to pay off the debt could save you money. For instance, as of this writing, the average interest rate for credit cards is 19.49 percent, whereas the typical rate on a personal loan is 9.41%.1 That difference should allow you to pay off the debt more quickly and pay less interest in total. Plus, it’s simpler to track and pay off a single debt obligation rather than multiple ones.

But a personal loan isn’t the only choice. You may be able to transfer your balances to a different credit card with an interest rate that is lower depending on whether you are eligible. Certain balance transfer offers eliminate interest during an extended period of promotion of six months or more.

2. Repaying other high-interest debts

While the individual loan is more expensive than some other types of loans, it isn’t necessarily the most expensive. If you have a payday loan, for example, it is likely to carry a far higher interest rate than a personal loan from banks. If you also have an old personal loan that has a higher interest rate than what you’re eligible to receive today and you want to replace it with the new loan could save you some money. Before doing this, however make sure you determine if there is a penalty for prepayment for the previous loan or application or origination fees for the new one. Those fees can sometimes be substantial.

3. Finance a Home Improvement or major Purchase

If you’re looking to purchase new appliances, installing a brand new furnace, or making another significant purchase, taking out a personal loan may be less expensive than financing with a seller or putting the cost on a credit card. If you do have any equity built up on your property, taking out a home equity loan or home equity line of credit may be cheaper. Of course, they are both secured which means you’ll have to put your home on the line.

4. Making a payment for an Major Life Event

Like any large purchase, financing an expensive event, such as an event like a bat or bar mitzvah, a major milestone anniversary party or wedding could be less expensive If you can pay for the event using an individual loan instead of using a credit card. According to a survey in 2021 conducted by Brides and Investopedia, one in five U.S. couples will use loans or investments to pay for their wedding. However important these occasions are, you could also think about scaling back slightly if you’re going in debt for years to be. This is why borrowing to fund a vacation might not be the best idea, unless it’s the holiday of an lifetime.4

A personal loan can help improve your credit score if you are able to make your payments punctually. In the absence of this, it can hurt your score.

5. Improve Your Credit Score

A personal loan and paying it back in a timely manner could increase your score on credit, particularly if you have a history of missed payments on other debts. If your credit report shows mostly credit card debt, then taking out a personal loan might also help the “credit mix.” The ability to have different kinds of loans and showing you can handle them responsibly is considered to be a positive for your score.5

That said, borrowing money you don’t really require in the hope of improving your credit score is a dangerous proposition. It is better to pay all your others bills promptly and striving to keep the lowest percent of your credit’s utilization (the sum of your credit you are currently using as compared to the credit you have available to you).

The Bottom Line

Personal loans are a good option if they’re in the right circumstances. But they aren’t cheap, and there are often more suitable alternatives. If you’re considering one, Investopedia’s personal loan calculator can help determine how much it will cost you.

KAS

The largest Downside in Payday Loans Near Me 550 Comes Down to This Phrase That Starts With “W”

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