The pros and cons of personal loans

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If you need extra cash to pay for home improvements, finance a wedding or consolidate high-interest debt, you might want to consider a personal loan. Used wisely, an unsecured personal loan can fill a void in your budget without risking your home or other assets.

As with other loans, rates for personal loans hinge on your credit score, income and debt-to-income ratio, and they’re not the right choice for everyone. Consider these pros and cons of personal loans before you make a decision.

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Answer a few questions to see which personal loans you pre-qualify for. The process is quick and easy, and it will not impact your credit score.

Advantages of personal loans

Personal loans are typically best for people who want to consolidate debt or finance a large purchase without putting up a home or vehicle as collateral. Benefits of personal loans include:

  • They are versatile. Unlike a car loan, a mortgage or a student loan, a personal loan can be used for many purposes — car repairs, medical bills, a dream vacation, debt consolidation and much more.
  • Interest rates are decent. Personal loan rates are favorable compared with rates on credit cards. As of late July 2020, the average personal loan rate is 11.88 percent, while the average credit card rate is 16.04 percent. For the most creditworthy consumers, personal loan rates hover in the range of 5 to 6 percent.
  • No collateral is required. Unlike mortgages and home equity loans, which are secured by your house, most personal loans are unsecured. This is especially attractive to consumers who have nothing of value to use as collateral.
  • A variety of lenders offer them. You can borrow personal loans from traditional sources, like banks and credit unions, or from online lenders, such as SoFi and LendingClub.
  • Excellent credit is not required. It’s possible to get a personal loan with bad credit. Some lenders even cater to borrowers with less-than-stellar credit. Just know that you’ll pay higher rates, which can exceed 35 percent.
  • Monthly payments stay the same. Interest rates on personal loans are fixed, so your payment is the same every month.
  • You can borrow the amount you need. Whether you need a few thousand dollars or $100,000, you can likely find a loan with limits that fit your needs — although the available amounts will depend on your credit score.
  • Loan approval is quick. While mortgages and home equity loans can take at least a month to close, it’s possible to apply for a personal loan online and have an answer the next day. If you are approved, the money is typically deposited into your bank account within a few days.
  • There’s a range of repayment terms. Many lenders have multiple repayment options for personal loans. Terms can range from a year to seven years, depending on your lender and your credit.

Disadvantages of personal loans

Personal loans are not right for everyone. Before signing up, consider some of their biggest drawbacks:

  • You can get trapped in a debt cycle. If you use a personal loan for debt consolidation, remember that you still have the old debt — it just looks different. If you wipe out your credit card debt with a personal loan and then start charging up big balances again, you’re digging yourself into a hole that can feel bottomless.
  • They have higher interest rates than some loans. Personal loans are often advertised at very low rates, but the advertised rate is usually the best rate available to applicants with the best credit. Secured loans, like home equity loans, usually have lower rates, since you have to put up your home as collateral.
  • They may come with origination fees. Many personal loans come with an “origination fee” of 1 percent to 6 percent of the amount borrowed. It covers the cost of processing the loan and is either rolled into the loan or taken out of the amount disbursed to you. If you borrow $10,000 and your origination fee is 4 percent, you’ll pay $400.
  • You may be penalized for paying it off early. Prepayment penalties may be charged if you retire your balance before the loan term is up. It’s something to watch for when you shop around. “The larger the loan, the more there could be additional fees,” says Theresa Williams-Barrett, vice president of consumer lending and loan administration for Affinity Federal Credit Union in New Jersey.
  • Fixed monthly payments are required. While fixed monthly payments are a plus to many borrowers, they can be a hurdle if you’re used to small monthly minimum payments and having as many years as you want to pay off credit cards. If your personal loan payment is $412 a month for five years and you are late or miss payments, the lender of an unsecured loan can sue you.
  • They attract scammers. Scams are rampant in the personal loans world. A shady lender might ask you to provide a prepaid debit card, for example, claiming that it will be used for loan fees or as collateral. Take every precaution to make sure your lender is legitimate. Check the Better Business Bureau (BBB) website and your state attorney general’s office to see whether a lender is accredited.

Are personal loans a good idea?

Personal loans are an attractive option if you need quick cash; with many lenders, especially those that operate online, funds can be made available in a matter of days. Interest rates can also be low, particularly if you have good credit, making personal loans a good way to consolidate and pay off credit card debt. Other good reasons to use a personal loan include paying for emergency expenses or remodeling your home.

However, personal loans are not a good idea for everyone. After all, personal loans are still a form of debt. If you already know that you have a habit of overspending, for instance, paying off your credit cards with a personal loan may not make sense if you’ll immediately begin racking up a new credit card balance.

You’ll also want to consider a personal loan’s repayment timeline and monthly payments. Before accepting a personal loan, use a personal loan calculator to determine whether or not you can afford the monthly payments for the five or seven years you’ll spend paying off the loan. Because you’ll be paying interest, in some cases it may make more sense to build up your savings to pay for a large purchase instead of taking out a personal loan and making payments with interest for many years.

Alternatives to personal loans

Depending on your circumstances, a personal loan may not be the best tool for you. Consider these options before you accept a loan.

Home equity loan or HELOC

If you own your home and have enough equity, you can borrow some of that equity with a home equity loan or home equity line of credit (HELOC).

A home equity loan is an installment loan, while a HELOC is a revolving line of credit similar to a credit card. Interest rates on home equity loans are often more favorable than those of personal loans.

Home equity loans are a popular way to finance home remodeling and repairs, but they can be used for many other things, such as education and medical expenses, vacations and debt consolidation. The biggest risk is that you could lose your home to foreclosure if you default on the loan.

View home equity rates

Tap into the value you have in your home to get the funds you need.

Credit card balance transfer

If you want to consolidate credit card debt, it might be better to find a good balance transfer offer. A credit card that lets you transfer balances and charges no interest or very little interest for a certain period of time will save you money if you pay off the balance before the special-offer period ends. Use our credit card balance transfer calculator to see how long it will take you to pay off your balances.

Credit card

If your credit score is low, it might cost you less to use a credit card for a large purchase than to take out a personal loan. While your interest rate may still be high, credit cards generally offer more flexible repayment terms. If you’re on the fence, try using Bankrate’s calculators to help you figure out the best way to borrow money.

Featured image by MinDof of Shutterstock.

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