More Americans are turning to personal loans for their small emergencies and life events or simply to pay down debt. And with interest rates on a 2-year decline, they look like a smart way to get additional funds.
The average personal loan rate has decreased 6.7 percentage points since the beginning of 2014 to 10.27%, while demand at credit unions has increased 4%, according to Perc Pineda, senior economist at Credit Union Association.
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“Personal loans give you flexibility,” says John Ulzheimer, a credit expert formerly with FICO and Equifax. “You can use the money for anything you want. You can use it to pay for a wedding, pay down credit card debt or student loan debt.”
But how do personal loans stack up to other sources of financing? Bankrate breaks it down here.
Personal loan or home equity?
Homeowners considering taking out a personal loan may also consider tapping home equity instead, either through a line of credit, or HELOC, a 2nd mortgage, or a cash-out refinance.
The benefit of using home equity is that the rates on these products are considerably lower than personal loans. The average home equity loan rate fell below 5.25% this fall. The average rate on a $30,000 home equity line was less than 4.75%, while a 30-year fixed refinance rate to about 4% this fall. Homeowners often can deduct the interest of these loans or lines of credit when filing their income tax return, Ulzheimer says.
The downside is that these loans are secured by your home, so if you have trouble making payments, you could lose your house, says Nicol Matthews, chief operating officer at Charlotte Metro Federal Credit Union in North Carolina. That’s not the case for personal loans, which are unsecured.
The rate on a HELOC also isn’t fixed like it is on a personal loan. Most HELOCs are tied to the prime rate — a common benchmark for consumer and business loans — which is also pegged to the federal funds rate, says Pava Leyrer, chief operating officer at Northern Mortgage Services in Grand Rapids, Michigan. If the Federal Reserve increases that rate, then the HELOC rate will also go up.
Leyrer says some banks charge annual fees between $50 and $95 to keep a HELOC open, and homeowners need to hold at least 10% equity in their home to get a line of credit. To do a cash-out refinance, homeowners need even more, at least 15% equity. And cash-out refinances can come with hefty closing costs, anywhere from several hundred dollars to a couple of thousand, says Leyrer. That may be enough to make a personal loan the savvier choice for some consumers.
As for 2nd mortgages, or home equity loans, those are on the wane, says Leyrer, so consumers may not find many options. Many major banks, such as Wells Fargo and Bank of America, have ditched these loans altogether to simplify their product offerings or to avoid dealing with new regulations.
Can credit cards compete?
Credit cards seem like an obvious place to turn when you need emergency funds. They’re easy because they often are in your wallet already and you don’t have to go through an application process.
“What makes credit cards attractive is that once a person has a credit card, there is no income verification to obtain a cash advance, assuming that the credit card is not maxed out, regardless if the person’s financial situation has changed such as a job change or job loss,” says Pineda.
Still, Pineda notes that credit card interest rates are often in the double-digits with cash advance rates even higher. Both are anchored to the U.S. prime rate, which means when the Fed raises rates, those rates increase, too.
Matthews says that her credit union offers credit card rates that are slightly lower than the personal loans rates, if your credit score is high enough. Still, she thinks a personal loan invites less potential trouble.
“You have a set term and set payment. You know if you do a 3-year loan, it will be paid off in 3 years,” she says. “The rate on the card is variable, so your payment can change. You can also add to the credit card balance,” meaning it will take longer to pay off.
Versus other kinds of ‘loans’
Personal loans definitely come out on top when stacked up against what Ulzheimer calls “2nd-tier lending options” such as pawn loans, payday loans or title loans, which typically come with sky-high interest rates and often predatory terms.
“Personal loans once had a reputation as being a subprime product,” he says. “But that’s not a deserved one now.”