The pros and cons of personal loans
If you need extra cash to pay for home renovations, finance a wedding, or consolidate high-interest debt, you might 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, personal loan rates depend on your credit score, income, and debt-to-equity ratio, and they’re not for everyone. Consider these advantages and disadvantages of personal loans before making 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, often between $1,000 and $50,000, in one lump sum. Personal loans are generally unsecured, meaning you don’t have to use collateral to secure the funds. Repayment periods can vary between one and 10 years. Personal loans can be used for almost anything, although some lenders may place restrictions on their use. Interest rates on personal loans are fixed, so your interest rate won’t change while you pay off your loan.
Applying for a personal loan is similar to applying for a credit card. You will need to enter your personal information, financial information and details regarding the desired loan. Before approving you, the lender will perform a rigorous credit check, which may temporarily lower your credit score. If your financial situation and credit score are good enough 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 open a Bankrate account to be prequalified for a personal loan in less than 2 minutes.
You will receive the funds for a personal loan all at once and start paying them back immediately. Your payment will be the same amount each month until you pay off your loan: a portion of your principal, plus interest charges.
Advantages of Personal Loans
Personal loans can offer advantages over other types of loans. Here are some advantages of using this type of financing over other options.
A lump sum
Because you get the loan paid off all at once, it may be easier to make a large purchase, consolidate debt, or use the loan all at once.
Fast funding times
Personal loans typically have quick approval and payment times, making them useful for emergencies or other situations where you need money fast. Some personal lenders can deliver the money the next business day.
No collateral requirement
Unsecured personal loans do not require collateral for you to be approved. This means that you don’t have to put your car, house or other asset as collateral that you will repay the funds. If you are unable to repay the loan on the terms agreed with your lender, you will suffer significant financial consequences. However, you don’t have to worry about losing a house or a car as a direct result.
Lower interest rates and higher borrowing limits
Personal loans often come with lower interest rates than credit cards. In July 2022, the average personal loan rate was 10.28%, while the average credit card rate was 16.80%. Consumers with excellent credit histories may qualify for personal loan rates between 10.3% and 12.5%. You may also qualify for a loan amount that exceeds your credit card limit.
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 using the cash, a personal loan can be a good alternative. Check with your lender about approved uses for the loan before applying.
Unlike short-term loans like payday loans and the like that charge very high interest rates, personal loans have a term of 2 to 10 years, depending on the lender. This allows you to have lower monthly payments and more reasonable interest rates.
Easier to manage
One of the reasons some people take out personal loans is to consolidate their debts, 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 terms 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.
Disadvantages of personal loans
Personal loans may be a good option for some, but they are not the right choice in all situations. Here are some negative points to consider before taking out a personal loan.
Interest rates may 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.
More eligibility criteria
Personal loans may have more stringent requirements than other funding option periods. If you have poor credit or a short financial history, fewer lenders will be available to you.
Fees and penalties can be high
Personal loans can come with fees and penalties that can drive up the cost of borrowing. Some loans come with origination fees of 1-6% of the loan amount. The fee, which covers loan processing, can either be built into the loan or subtracted from the amount paid to the borrower.
Some lenders charge prepayment penalties if you pay off the balance before the end of your loan term. Before applying, review all fees and penalties for any personal loan you are considering.
With a personal loan, you add another monthly payment. If you’re not careful, it can lead to problems with your daily expenses or paying other essential bills.
Increase in debt
Personal loans can be a debt consolidation tool like credit card balances, but they don’t address the root cause of the debt. When you pay off your credit cards with a personal loan, it frees up your available credit limit. For those who spend too much, it offers the possibility of accumulating more charges rather than freeing themselves from debt.
Higher payments than credit cards
Credit cards come with small minimum monthly payments and don’t have a deadline to pay off your balance in full. Personal loans require a higher fixed monthly payment and must be repaid at the end of the loan term.
If you’re consolidating credit card debt into a personal loan, you’ll have to adjust to the higher payments and loan repayment schedule or risk default.
How to decide if a personal loan is right for you
Personal loans are an attractive option if you need money quickly. Here’s how to discern if a personal loan might be right for you:
- You need funds quickly. With many lenders, especially those operating online, funds can be made available within days.
- You have a solid credit rating. The lowest interest rates are reserved for borrowers with good credit.
- You want to pay off high interest debt. Personal loans are a great way to consolidate and pay off expensive credit card debt.
- You will use the funds for necessary expenses. Other good reasons to use personal loans include paying for emergency expenses or renovating your home.
However, personal loans are not a good idea for everyone. After all, personal loans are still a form of debt. Here are some reasons why a personal loan might not be right for you:
- You have no viable purpose for the funds. It may be tempting to take out a loan for extra funds. But if you don’t have a plan for how the funds will be used, you risk spending money and paying unnecessary interest on non-essential items.
- You are used to spending too much. Paying off your credit cards with a personal loan may not make sense if you immediately start building up a new credit card balance.
- You can’t afford the monthly payments. Consider the repayment schedule and monthly payments for a personal loan. Use a personal loan calculator to determine whether or not you can afford the monthly payments for the length of time you will spend paying it back.
- You don’t need money urgently. It may be a good idea to build up your savings to pay for a big purchase instead of taking out a personal loan and making payments with interest for many years.
Alternatives to Personal Loans
There are instances where a personal loan may not be the most sensible option.
If you have enough 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 the same way as a credit card. One disadvantage of having a home equity loan or 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, as long as you pay off the balance before the end of the special offer period. Our credit card balance transfer calculator will help you see how long it will take to pay off your balance.
If your financial shortfalls are the result of overspending, a realistic spending plan is a more feasible option. Otherwise, you risk accumulating an excessive amount of debt, which could take some time to eliminate.
At the end of the line
Before taking out a personal loan, plan how you will use the funds and how you will repay them (with interest). Weigh the pros and cons of taking out a personal loan versus using another financing option. Investigate alternatives such as a home equity loan, HELOC, or credit card balance transfer. Use a discount rate 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. Remember to read the fine print, including fees and penalties. Once you have all the data, decide if the pros of a personal loan outweigh the cons before committing.