How a personal loan can help you build wealth

Personal loans are often thought of as debt products used to finance an expense when money is tight. Although personal loans can be a great solution if you’re in a financial bind and need to pay for things like an unexpected medical bill or an expensive car repair, they can also be used to improve your financial situation.

Personal loans can help you build wealth in three ways. First, personal loans, particularly debt consolidation loans, can be used to get rid of high-interest debt to improve your cash flow. You can also use the funds to take advantage of a good investment opportunity, or finance some much-needed home renovations or repairs that could potentially increase the value of a property.

How to use personal loans to build wealth

Just like credit cards, personal loans are a highly versatile credit product, as lenders place very few restrictions on how you can use the funds. But unlike credit cards, personal loans are disbursed in a lump sum and come with a set repayment schedule and a fixed interest rate.

This alone makes them a better option when it comes to building wealth, as these factors can help you avoid the temptation that often comes attached with revolving credit, such as overspending or only paying the minimum due, both of which can worsen your financial situation.

“A personal loan can give the borrower clarity on what is there to spend and a plan to pay the debt off,” David Mullins, CFP and wealth advisor at David Mullins Wealth, says. “Of course, debt is not typically the answer, and spending behaviors must first be changed before such strategies can become beneficial.

In other words, for you to be able to use a personal loan successfully to build wealth, you must first have a plan and be on solid footing when it comes to your finances and spending behaviors. Otherwise, you’re at risk of falling into an endless cycle of debt.

Debt consolidation

If you’re struggling with high-interest debt, such as credit card debt, then taking out a personal loan to consolidate debt could be a great option to help you increase your net worth. Personal loans tend to have much lower interest rates compared to those of credit cards, plus their interest is fixed, meaning you’re protected against market fluctuations — something credit cards can’t offer.

According to CreditCards.com, credit cards currently have an average interest rate of just under 21 percent, while personal loans have an average interest rate of 11.29 percent — that’s a 46 percent difference.

By consolidating multiple credit cards into a single loan with a fixed interest rate and a set payoff date, you could get rid of debt faster and save money on interest along the way to improve your monthly cash flow.

For instance, let’s say you have $5,910 in credit card debt, which is the national average, with a 21 percent interest rate. If you take out a 36-month personal loan with a 11.29 percent interest, your monthly payment will go from $223 to $194, and you’ll save over $1,000 on interest over the life of the loan.

That said, to be able to maximize your savings with a debt consolidation loan, you’ll need to have good to excellent credit, plus a stable source of income. Additionally, when looking at debt consolidation loans, savings can fluctuate not only based on your interest rate but also on the fees charged by lenders. Make sure you factor these charges in as part of the equation to determine whether a debt consolidation loan will actually save you money or if a debt avalanche or snowball payoff strategy may be a better option.

Investing

Contrary to what many believe, you can use a personal loan to invest. This investment can be using the funds to pursue a certification to advance your career and increase your income, but it can also be investing in the stock market. Likewise, you can also use a personal loan to purchase an asset that you can rent or use to generate income. Personal loans can come with interest rates as low as 4.6 percent, depending on the lender.

That said, for this to work, you will need to have excellent credit and stable finances, otherwise, you won’t be able to qualify for the lowest personal loan rates. And, the higher the interest, the less earnings you’ll be able to generate through your investment, thus defeating the initial purpose of the loan.

“When using personal loans to build wealth you must be purchasing assets that will appreciate or cash flow more than the interest rate, including maintenance costs — if any,” Mullins says. “One mistake entrepreneurs can make is to assume everything will go right and be overly optimistic on financial projections. Make sure you calculate worst case scenarios.”

Financing home improvements

Another way personal loans can be used to build wealth is to make renovations or improvements to a property, including your primary home or rental, such as an Airbnb. Home improvement loans, which are a type of personal loan, are an ideal choice for these types of projects.

Just like other personal loans, home improvement loans come with fixed interest rates and a set repayment schedule. What’s more, some lenders may offer repayment terms of up to 144 months on home improvement loans, which can give you a ton of flexibility, especially if you’re planning on doing extensive renovations. They can also be a good alternative to secured loans, such as a home equity loan or a home equity line of credit (HELOC), as you’re not at risk of losing your home if you default on payments.

However, just like using a personal loan for investing, it’s best if you have good or excellent credit for home improvement loans for them to be worth your while — interest-wise.

“When it comes to home improvements with a personal loan, understand you will probably not get 100 percent of your investment back when you resell,” Mullins says.

“What you value and what the market values will likely differ. Nevertheless, if you are dead set on that kitchen remodel, a personal loan can be a better funding option than maxing out credit cards or even taking equity of your home. Just be sure the costs associated with these improvements can be enjoyed even if they are never recouped,” he adds.

What is considered rich?

Americans’ budgets have been stretched thin over the last several months, thanks in part to stubborn inflation and a rising rate environment. According to Bankrate’s latest survey, most Americans feel they need about $233,000 a year to live comfortably — more than triple the amount of the average salary in the nation, which sits slightly over $75,000.

That said, the vast majority of respondents say that $233,000 is just the number to live a normal everyday life. To feel rich, which basically means that they have enough wealth built to not have to worry about feeling financially insecure, Americans say they’d need an annual income close to $500,000. However, this fluctuates by generation, gender, race and ethnicity, as well as parental status, as shown below.

Although it may not be an ideal solution for everyone, personal loans can give many the opportunity to build wealth by providing the seed capital needed to take advantage of economic opportunities they’d otherwise miss out on due to lack of liquidity.

To determine whether a personal loan may be the best solution for you to increase your net worth, make sure to assess your financial situation thoroughly and calculate how payments will fit into your budget, especially if things were to get tough economically. Additionally, have a financial professional evaluate your plan for investment — including potential risks — to better understand whether the reward will be worth the risk.