The pros and cons of personal loans
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Personal loan funds can be used for a number of purposes, including debt consolidation and medical expenses. It can be a good solution if you need funds fast — some lenders can deposit funds into your account as fast as the next business day. Plus, average rates are typically lower than some other forms of debt, like credit cards.
But like all financial products, personal loans have drawbacks as well. For example, some lenders charge high fees, which can greatly increase your borrowing costs. Before you take one out, you should weigh the pros against the cons to determine whether it’s the right financing option for you — and consider alternatives.
Pros and cons of personal loans
As with any other form of debt, there are advantages and disadvantages to be aware of before applying for a personal loan. Here’s what you need to know prior to signing on the dotted line.
Pros of personal loans
- One lump sum
- Fast funding times
- No collateral requirement
- Lower interest rates
- Flexibility and versatility
- Extended loan terms
- Easier to manage
Cons of personal loans
- Interest rates can be higher than alternatives
- More eligibility requirements
- Fees and penalties can be high
- Additional monthly payment
- Increased debt load
- Higher payments than credit cards
- Potential credit damage
Pros of personal loans
Personal loans can offer benefits over other types of loans. Below are a few advantages of using this type of financing over other options.
One lump sum
Because you get the loan payment all at once, it can be easier to make a large purchase, consolidate debt or otherwise use the loan all at once. Plus, you’ll get a fixed interest rate and predictable monthly payment, making the loan easier to manage.
Why this matters: Receiving a lump-sum payment with a fixed interest rate can be easier to manage and help you avoid late payments.
Fast funding times
Personal loans generally have fast approval times and payment times, making them useful for emergencies or other situations where you need money quickly. Some personal loan lenders can deposit the loan proceeds to your bank account as soon as the next business day.
Why this matters: If you need money fast, a personal loan can be a good financing option.
No collateral requirement
Unsecured personal loans don’t require collateral for you to get approved. This means you don’t have to put your car, home or another asset up as a guarantee that you’ll repay the funds. If you cannot repay the loan based on the agreed-upon terms with your lender, you’ll face significant financial and credit consequences. But unlike a secured personal loan, you don’t have to worry about losing a home or a car as a direct result.
Why this matters: With an unsecured loan, a lender can’t take your collateral for failing to repay the loan, at least without a court’s permission.
Lower interest rates
Personal loans often come with lower interest rates than credit cards. As of June 2023, the average personal loan rate was 11.05 percent, while the average credit card rate was 20.44 percent. Consumers with excellent credit history can qualify for personal loan rates of around 10.3 percent to 12.5 percent. You may also qualify for a higher loan amount than the limit on your credit cards.
You can potentially save money on interest if you have good credit and take out a personal loan instead of a credit card.
Flexibility and versatility
Some loans can only be used for a certain purpose. For example, purchasing a vehicle is the only way to use the funds if you take out a car loan. Personal loans can be used for many purposes, from consolidating debt to paying medical bills.
A personal loan can be a good alternative if you want to finance a major purchase but don’t want to be locked into how you use the money. Check with your lender on the approved uses for the loan before applying.
Why this matters: A personal loan can be a good solution if you need to borrow money for virtually any reason.
Extended loan terms
Unlike short-term loans like payday loans and others that charge high interest rates, personal loans range from 2-10 years, depending on the lender. Consequently, you’ll get a reasonable monthly payment and ample time to repay what you borrow.
Why this matters: Longer loan terms can make borrowing money more affordable. Just keep in mind that, the longer your loan term, the more interest you’ll pay over the life of the loan.
Easier to manage
Some people take out personal loans to consolidate debt, such as multiple credit card accounts. A personal loan with a single, fixed-rate monthly payment is easier to manage than several credit cards with different interest rates, payment due dates and other variables.
Borrowers who qualify for a personal loan with a lower interest rate than their credit cards can streamline their monthly payments and save money.
Why this matters: If you qualify for a personal loan with a lower interest rate than your current debt, you can save thousands of dollars in interest.
Cons of personal loans
Personal loans can be a good option for some, but they are not the right choice in all situations. Here are a few negatives to consider before taking out a personal loan.
Interest rates can be higher than alternatives
Interest rates for personal loans are not always the lowest option. This is especially true for borrowers with poor credit, who might pay higher interest rates than credit cards or a secured loan requiring collateral.
Why this matters: The lower your credit, the more likely a lender will charge you a high interest rate. As a result, you could end up paying thousands of dollars more in interest than someone with good credit.
More eligibility requirements
Personal loans can have more strict requirements than other types of funding options. If you have poor credit or a short financial history, fewer lenders will be available to you. Furthermore, some lenders don’t allow co-signers, which can be used to strengthen your approval odds if you have minimal credit history or your credit score is low.
Why this matters: Qualifying for a personal loan may be more difficult if you have bad credit.
Fees and penalties can be high
Personal loans may come with fees and penalties that can drive up the cost of borrowing. Some loans come with origination fees of 1 percent to 6 percent of the loan amount. The fees, which cover loan processing, can either be rolled into the loan or subtracted from the amount disbursed to the borrower.
Some lenders charge prepayment penalties if you pay the balance off before the end of your loan term. Before applying, review all fees and penalties of any personal loans you are considering.
Why this matters: Fees and penalties can greatly increase your borrowing costs.
Additional monthly payment
With a personal loan, you add another monthly payment. If you are not careful, a personal loan can lead to loan term issues with your budget if it’s not accounted for when you take out the loan and making the monthly payment causes you to overdraw your account and send your budget into the red.
Why this matters: A personal loan can put a strain on your budget if you borrow more than you can afford.
Increased debt load
Personal loans can be a tool for consolidating debt such as credit card balances, but they do not address the cause of the debt. Paying your credit cards off with a personal loan frees up your available credit limit. This allows overspenders to rack up more charges rather than free themselves from debt.
Why this matters: Although taking out a personal loan can help you consolidate high-interest debt, it can cause you to go deeper into debt if you don’t address any bad spending habits.
Higher payments than credit cards
Credit cards come with small minimum monthly payments and no deadline for paying your balance off in full. Personal loans require a higher fixed monthly payment and must be paid off by the end of the loan term.
If you consolidate credit card debt into a personal loan, you’ll have to adjust to the higher payments and the loan payoff timeline or risk defaulting.
Why this matters: Depending on your finances, higher monthly payments can be more difficult to manage. As a result, you might be at higher risk of defaulting on the loan.
Potential credit damage
If you don’t keep up with your monthly payments or fail multiple applications, personal loans can have a potentially detrimental impact on your credit score. When you apply for a loan the lender will conduct a hard-credit inquiry, which will knock your score down a few points and the amount of debt you owe vs. your annual income can damage your credit.
However, the initial degradation doesn’t last long with a positive repayment history and your score will grow as you make monthly payments and pay down your debt. Your repayment history makes up the largest percentage – 35 percent – of your Fico Score and your amounts owed makes up 30 percent.
Why this matters: Weak repayment history and a high debt-to-income ratio will likely result in a significant drop in credit, which can make it difficult to get approved for things like a mortgage and a car loan.
How to decide if a personal loan is right for you
Personal loans are an attractive option if you need quick cash. Here’s how to discern whether a personal loan might make sense for your situation:
- You need the funds quickly. With many lenders, especially those that operate online, funds can be made available in a matter of days.
- You have a strong credit score. The lowest interest rates are reserved for borrowers who have good credit.
- You want to pay off high-interest debt. Personal loans are a good way to consolidate and pay off costly credit card debt.
- You’ll use the funds toward necessary expenses. Other good reasons to use personal loans include paying for emergency expenses or remodeling your home.
However, personal loans are not a good idea for everyone. Below are a few reasons why a personal loan might not be right for you:
- You don’t have a viable purpose for the funds. It can be tempting to take out a loan to have extra funds on hand. But if you don’t have a plan for how the funds will be used, you risk spending money on and paying unnecessary interest on items that are not essential.
- You have a habit of overspending. Paying your credit cards off with a personal loan may not make sense if you’ll immediately begin building up a new credit card balance.
- You can’t afford the monthly payments. Consider a personal loan’s repayment timeline and monthly payments. Use a personal loan calculator to determine whether or not you can afford the monthly payments for the term you’ll spend paying it off.
- You don’t need the money urgently. It might make 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.
How to choose the best personal loan
When you’re considering taking a personal loan, it’s important to shop around, compare offers, and get the best deal and loan terms for your needs. As you comparison shop there are some key factors to evaluate from lender to lender, which can help you assess the competition and zero in on the best personal loan. The factors to consider include:
- Interest rate
- Loan amounts available
- Fees associated with the loan
- Loan terms available
- Customer service support and experience
- Types of loans available
The best loan for you will depend on your unique needs and financial qualifications. But seeking the most competitive interest rate possible, as well as minimal to no additional fees associated with the loan is a good rule of thumb. A loan company that offers readily available customer service representatives and a variety of loan types can also be beneficial.
Alternatives to personal loans
If you think taking out a personal loan isn’t right for you, here are some alternative options to consider:
- Home equity loan. If you have enough equity in your home, you can borrow against it with a home equity loan. A home equity loan operates similarly to a personal loan in that it comes with fixed installment payments and interest rates. But a major downside is that if you fail to repay the loan as promised, a lender can foreclose on your home.
- Home equity line of credit (HELOC). Another way to tap your home’s equity is to take out a HELOC. A HELOC operates like a credit card — it usually comes with a variable interest rate and you can borrow funds as needed. Similar to a home equity loan, a lender can foreclose on your home if you fail to repay the loan.
- 0% APR credit card. If you have good to excellent credit, you might qualify for a credit card with an interest-free promotion period. As long as you repay what you borrowed before this promotional period ends, you can forgo paying interest altogether. However, you’ll be responsible for paying interest on any remaining balance at the card’s standard APR — which can be high.
Before taking out a personal loan, make a plan for how you’ll use the funds and how you’ll repay them (with interest). Weigh the pros and cons of taking out a personal loan rather than using another financing option. Review alternatives such as a home equity loan, a HELOC or a credit card balance transfer. Use a Bankrate calculator to help you determine the best borrowing option for you.
If you’re considering a personal loan, get quotes from several lenders to compare interest rates and loan terms. Don’t forget to read the fine print, including fees and penalties. Once you have all the data, decide if the benefits of a personal loan outweigh the drawbacks before making a commitment.