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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What is a personal loan?

A personal loan is a type of installment loan that gives you a fixed amount of money, often anywhere from $1,000 to $50,000, in one lump sum. Personal loans are usually unsecured, meaning you don’t have to use collateral to secure funds, and repayment terms can be between one and 10 years. Personal loans can be used for almost anything, although specific lenders may impose restrictions on their use. Interest rates on personal loans are also fixed, so your interest rate will not change while you repay your loan.

How it works

Applying for a personal loan is similar to applying for a credit card. You’ll need to enter your personal information, your financial information and the details about your desired loan. Before approving you, the lender will have to run a hard credit check, which may temporarily lower your credit score. If your financial picture and credit score is sufficient for the lender — often you need a credit score in the mid-600s — the lender will set your interest rate, loan amount and terms.

You’ll receive personal loan funds all at once and begin paying them back immediately. Because personal loan interest rates are fixed, your monthly payment will be the same amount every month: a portion of your principal, plus interest charges. You’ll make these fixed monthly payments each month until your loan is paid off.

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.

One of the biggest benefits of personal loans is that 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 also decent compared to the rates on credit cards. As of late November 2020, the average personal loan rate is 11.88 percent, while the average credit card rate is 16.03 percent. For the most creditworthy consumers, personal loan rates hover in the range of 5 to 6 percent. And because interest rates on personal loans are fixed, your payment is the same every month.

A variety of lenders offer personal loans, which means that you can shop around with banks, credit unions and online lenders in order to find the best rate. Once you find a loan, approval and receipt of funds is quick — usually only a few business days.

Finally, personal loans are attractive for consumers with little collateral or a low credit score. Unlike mortgages and home equity loans, most personal loans don’t require you to use your assets to secure the loan. And if you have poor credit, you may find a bad-credit lender willing to lend you funds, albeit with a higher interest rate.

Disadvantages of personal loans

Personal loans are not right for everyone — they do have their drawbacks. For one, although they have lower interest rates than credit cards, they may have higher rates than secured products like home equity loans. This is particularly true if you have poor credit. If you have a credit score in the low 600s, expect to pay the highest rates advertised on lender websites, which may exceed 30 percent.

Also be aware of fees and penalties. 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. Prepayment penalties may also be charged if you retire your balance before the loan term is up.

Additionally, keep in mind that 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.

Are personal loans right for you?

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.

The bottom line

For some, the benefits of personal loans outweigh the drawbacks. Whether a personal loan is right for you comes down to how you manage your money and what your needs are. If you are confident in your ability to make payments on a personal loan (with interest) for years to come, it could be a good way to pay for a large expense or consolidate debt. In any case, shop around with a few lenders before making a commitment to see what interest rates and terms are available to you.

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

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 a Bankrate calculator to help you figure out the best way to borrow money.

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