The pros and cons of personal loans
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.
What is a personal loan and how does it work?
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. Repayment terms can range 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 fixed, so your interest rate will not change while you repay your loan.
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 run a hard credit check, which may temporarily lower your credit score. If your financial picture and credit score are 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 can sign up for a Bankrate account to get prequalified for a personal loan in under 2 minutes.
You’ll receive personal loan funds all at once and begin paying them back immediately. Your payment will be the same amount every month until your loan is paid off: a portion of your principal, plus interest charges.
Pros of a personal loan
Personal loans can offer benefits over other types of loans. Below are a few advantages of using this type of financing over other options.
Flexibility and versatility
Some types of loans can only be used for a certain purpose. For example, if you take out a car loan, the only way to use the funds is to purchase a vehicle. Personal loans can be used for many purposes, from consolidating debt to paying off medical bills.
If you want to finance a major purchase but don’t want to be locked into how you use the money, a personal loan can be a good alternative. Check with your lender on the approved uses for the loan before applying.
Lower interest rates and higher borrowing limits
Personal loans often come with lower interest rates than credit cards. As of September 2021, the average personal loan rate was 10.46 percent, while the average credit card rate was 16.27 percent. Consumers with excellent credit history can qualify for personal loan rates in the range of 6 percent to 8 percent. You may also qualify for a higher loan amount than the limit on your credit cards.
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 other asset up as a guarantee that you’ll repay the funds. If you’re unable to repay the loan based on the agreed-upon terms with your lender, you’ll face significant financial consequences. However, you don’t have to worry about losing a home or a car as a direct result.
Easier to manage
One reason some people take out personal loans is 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 in the process.
Drawbacks 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 with credit cards.
If you have sufficient equity in your home, you can borrow against it using a home equity loan or a home equity line of credit (HELOC). A home equity loan is an installment loan, while a HELOC works similarly to a credit card. One downside to having a home equity loan or a HELOC is that your home is used as collateral. If you default on the loan, you risk losing your home to foreclosure.
Credit card balance transfer offers are another alternative to personal loans. You can save money with a good balance transfer offer, provided you pay the balance off before the special offer period ends. Our credit card balance transfer calculator will help you see how long it will take to pay off your balance.
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.
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 have to 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.
Can increase debt
Personal loans can be a tool for consolidating debt such as credit card balances, but they do not address the cause of the debt. When you pay your credit cards off with a personal loan, it frees up your available credit limit. For overspenders, this offers an opportunity to rack up more charges rather than free themselves from debt.
Is a personal loan 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. After all, personal loans are still a form of debt. Below are a few reasons a personal loan might not be right for you:
- 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.
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.