The pros and cons of personal loans

6 min read

If you need extra cash to pay for home improvements, a wedding or to consolidate high-interest debt such as credit cards, 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.

Personal loans are a popular financing option for consumers, and demand is rising. Between Q3 2018 and Q3 2019, the number of personal loans climbed from 20.3 million to 22.5 million, and unsecured balances rose from $132 billion to a record high of $156 billion, according to the latest figures from TransUnion. The average personal loan borrower has a balance of $8,998.

Like other loans, rates for personal loans hinge on your credit score, your income and debt-to-income ratio. Get a free copy of your credit report before you apply for a personal loan.

Get pre-qualified

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.

Consider these pros and cons of personal loans before you make a decision.

Advantages of personal loans

1. They are versatile

Unlike a car loan, a mortgage or a student loan, a personal loan can be used for many purposes. You can use it to pay for car repairs, medical bills, a dream vacation, to consolidate credit card debt — pretty much whatever you need.

However, just because you can use a personal loan for mostly anything doesn’t mean you should. Know the top reasons to use a personal loan.

2. Interest rates are decent

Personal loan rates are favorable compared with rates on credit cards. Federal Reserve figures for Q3 2019 show that the average interest rate on a 24-month personal loan is 10.36 percent, while the average rate on a credit card is 16.97 percent. For the most creditworthy consumers, personal loan rates hover in the range of 6 to 7 percent.

You don’t have to put up collateral either. Unlike a mortgage or home equity loan, which is collateralized by your house, most personal loans are unsecured. This is especially attractive to consumers who have nothing of value to use as collateral.

3. They are good for debt consolidation

One of the most popular uses of personal loans is to pay off higher-interest credit card debt.

“You may be able to lower your monthly payment and interest rate,” says Kathryn Bossler, quality assurance specialist at GreenPath Financial Wellness, a Michigan-based nonprofit that helps people through financial crises.

4. A variety of lenders offer them

Along with traditional banks and credit unions, you can borrow personal loans at online banks, such as Discover; online nonbank lenders, such as SoFi; and peer-to-peer lenders, such as LendingClub.

5. Excellent credit is not required

It’s possible to get a personal loan with bad credit. Some lenders cater to borrowers with less-than-great credit. Just know that you’ll pay higher rates, which can exceed 35 percent.

6. Monthly payments stay the same

Interest rates on personal loans are fixed, so your payment is the same every month.

“One of the things I like is that it gives you a clear beginning and end to knocking out your debt,” says J.J. Montanaro, a certified financial planner with USAA. “You can see the light at the end of the tunnel.”

7. You can borrow the amount you need

Whether you need a few thousand dollars or $100,000, you can find a loan with limits that fit your needs. Again, a lot depends on your credit score.

8. Loan approval is quick

While mortgage 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 or within a few days. If you are approved, the money typically is deposited into your bank account within a few days.

9. You have enough time to pay it off

Unlike highly risky payday loans, personal loans give you a reasonable amount of time to repay. Terms can range from a year to seven years, depending on your lender and your credit.

Disadvantages of personal loans

1. 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.

2. They have higher interest rates than some loans

A borrower with good credit could probably get a better rate on a home equity loan than a personal loan. 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. Be sure to shop around for the best rate.

3. They 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.

4. You may be penalized for paying it off early

Known as a prepayment penalty, this fee is 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. “You have to be really careful (when) comparing.”

5. Your monthly payment and loan term are fixed

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.

6. 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 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 to see whether a lender is accredited.

Also, lenders and brokers must be registered in the states where they conduct business. Look for this information at the lender’s website or contact your state attorney general’s office for further verification.

Alternatives to personal loans

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

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.

A home equity loan is an installment loan, while a line of credit, known as a HELOC, is a revolving line of credit similar to a credit card. Interest rates on home equity loans are often more favorable than 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 what you need than it is to take out a personal loan. Credit cards are unsecured and the repayment terms offer more flexibility. Use Bankrate’s calculators to help you figure out the best way to borrow money.

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