While it’s a good financial practice to set aside an emergency fund for unexpected expenses, that isn’t always enough to cover every expense you might have. Sometimes you may encounter large expenses where you can’t afford to pay for it from your bank account. A few examples of this might include medical expenses, moving costs, consumer products and home repairs.
To fill in the gap, a personal loan might be a good option, especially if you can qualify for one with a low interest rate. A personal loan can often be a better option than using high-interest credit cards for these types of unexpected expenses. Here are five ways a personal loan could help to save you money in the long run.
1. To help consolidate credit card debt
Personal loans typically have lower average interest rates than credit cards. For example, as of September 8, 2021, the average credit card interest rate was 16.21 percent, while the interest rate on the average personal loan was 10.46 percent. Because of the rate difference, personal loans are commonly used to pay off credit card debt. Some lenders even have personal loans designed for that specific purpose.
If you’re struggling to make payments on your credit card debt or your minimum monthly payments are too high because of interest charges, a personal loan with a lower interest rate may be the best option to help you save money and pay off your debt.
The downside to using a personal loan to consolidate debt is that your personal loan’s interest rate may be higher than your credit card’s interest rate if you have a credit score that falls within the poor to fair range — 669 or below, based on the FICO scoring model. Some lenders have interest rates as high as 36 percent.
To improve your chances of qualifying for a lower rate, focus on improving your credit score. Two ways to do this are to pay down your debt and make sure you pay your bills on time. If you don’t have time to wait until your score improves, try applying for a loan with a co-signer or co-borrower who has better credit.
2. To help you finance a one-time big expense
When big moments happen in life and you find yourself in need of cash for a large one-time expense, a personal loan may be the most practical and inexpensive way to borrow money for that item or experience.
Because lenders typically allow you to use a personal loan for almost anything, it can be used to pay for a vacation, wedding, boat or one-time medical procedure. If you decide to take out a personal loan for a want and not a need, calculate your loan payments to see if you can afford to repay the loan — using a loan calculator may help.
One negative to using a personal loan for a one-time expense is that the ease of getting a personal loan might make you more likely to use it for non-critical expenses. It’s best to save up for these types of expenses if possible rather than going into debt for something like a vacation. Also, missing a payment or defaulting on the loan can cause serious damage to your credit score, making it more difficult for you to take out loans in the future.
3. To help you ditch high interest rates
Personal loans are more flexible than other lending options, which means that you can agree to a repayment term that may range from six months to 10 years. A good strategy to ditch high interest rates sooner could be taking out a debt consolidation loan to consolidate multiple debts.
If the monthly bill for your personal loan is lower than it was with multiple bills, consider paying more than the minimum due. Paying off your loan early could help you save hundreds of dollars in interest. Before you do this, however, make sure your lender doesn’t charge you a prepayment fee.
Another alternative to using a personal loan to ditch high interest rates is to just focus on paying down your debt using the debt snowball or debt avalanche method. Depending on how much debt you have and your financial situation, that may work out better than taking out another loan to pay off your debt.
4. To help increase your credit score
If you have credit card debt and are spending close to your spending limit every month on your cards, your credit utilization ratio will increase and lenders will consider you a higher risk.
Personal loans can help with credit utilization, especially if they replace your credit card debt. Credit cards are revolving loans, whereas personal loans come with a fixed repayment term, meaning there’s a timeline for you to pay back the loan. This will help you lower your credit utilization ratio and diversify your debt types, helping rather than hurting your credit score.
5. To help you avoid pesky pop-up fees
A major benefit of choosing a personal loan when you’re in need of funding for a big expense is that you can review the lender’s fees, if any, before accepting the loan. Common fees include late payment fees, prepayment fees, returned check fees and origination fees. The lender will share this information with you when it sends you the Truth-in-Lending Disclosure — a document that outlines the loan’s APR, fees (if any) and finance charges.
Knowing the fee structure before signing your loan agreement will help you avoid any pop-up fees.
The bottom line
Using a personal loan to refinance credit card debt can save you a ton of money if you secure a lower rate. In addition, using one can help you save on your dream wedding or vacation if you choose a loan amount you can comfortably repay.
However, taking on a loan you can’t afford for wants should be avoided, if possible. Doing so can put you in a bad spot financially and ruin your credit if you miss a payment or default on the loan.