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Updated Dec. 3, 2019: Most loans have straightforward uses. A mortgage loan pays for a house. An auto loan pays for a car. A student loan, college costs.
Then there are personal loans for funding — you guessed it — something personal in nature. You can use the money towards just about anything and everything (as long as it’s not illegal). Personal loans are unsecured, relatively easy to obtain and usually available in several amounts, from small to jumbo size.
Sounds like a pretty sweet arrangement, having the freedom to access some cash for just about anything you want. But if you’re thinking of taking out a personal loan, get to know it a little better first.
There are advantages and disadvantages. You need to know when a personal loan is worth it, and when it might put you at risk of debt or default.
Before setting out on the personal loan front, first consider some of the pros and cons and weigh some of your options.
Personal loans are unsecured. Secured loans, like mortgages, auto loans or payday loans require some form of collateral (property, like a house, car or other item) in case you go into default and the lender needs something of value to compensate for the loss. Personal loans, on the other hand, are unsecured, so putting up collateral is not necessary.
Generous loan amounts. Personal loans come in all sorts of varying amounts; you can get one starting in the vicinity of $1,000, all the way up to $100,000.
Fast application/approval time. Since personal loans can be obtained through a variety of independent and online lenders, expediting approval within 24 hours is not unlikely, since the general turnaround process is more streamlined than that of a traditional bank or financial institution.
Interest rates may tend to be on the high side. Because personal loans are usually unsecured, they’re perceived by lenders as riskier, so higher interest rates may apply. Personal loan annual percentage rates can reach into double digits even for borrowers with stellar credit. High interest rates may raise the chance of making payments unaffordable.
Loan periods tend to be shorter and accelerated. Fixed- and variable-rate mortgages traditionally have terms of 15 or 30 years. Standard student loan repayment plans are about 10 years. Even most auto loans reside in the 48- to-72-month period. Personal loan repayment periods may tend to be on the shorter side, often three to four years or less, placing pressure on borrowers to pay up early.
Lenders can still sue you. Though you have no obligation to secure your personal loan with some sort of collateral, a lender can still pursue legal action against you upon delinquency or default, and place a lien on your assets to secure repayment. Go to court, and you could get hit with court or attorney fees, plus other charges. And if a judgment is issued against you, it’ll show up on your credit report.
There’s no one-size-fits-all scenario with personal lending. Noting some of these possible benefits and drawbacks, there are some instances where a personal loan may benefit you, and some where it might not.
Reducing/consolidating credit card debt. With the average national credit card interest rate over 16% according to US News, it’s no surprise why so many people may find themselves in debt. Using a personal loan to pay off or consolidate your credit card debt can be a more cost effective option, especially if you can land an APR on your loan lower than on your cards. Learn more about debt consolidation loans.
Paying off medical bills. Out-of-pocket costs can rack up if you visit the doctor’s office without a health insurance plan, quickly sending you on the fast track to debt. A lower-interest personal loan can help pay off some of your medical expenses. Thankfully, you’ll have a bit of time to search for the right loan, since medical debt won’t appear on your credit report until six months after you’ve been billed.
Home improvements. If you want to make improvements to your home to build equity, but don’t have enough equity just yet to borrow a line of credit against the value of your house, a personal loan could do the trick to pay for those renovations. In this case, when your mortgage payments prevent you from freeing up some discretionary cash to use towards a remodel project, a personal loan is a more feasible option than dipping into your savings account or putting it down on a credit card.
Major life events. Some expenses are unexpected, others are so cost-prohibitive that there’s no time to save up for them, and others still are a combination of both. You can pay for significant life events, like a major move cross country, or planning and paying for a funeral, with a personal loan. (Just make sure that if you’re moving for a new job, your income allows you to make your loan payments — or, that estate plans cover as much as possible before borrowing too much.)
For building credit. If you don’t qualify for a credit card and are looking to boost your credit score, a personal loan could do the trick. Take out a small amount strictly to pay it back, not to spend on anything. The loan should diversify your credit mix, improve your credit utilization ratio, and reflect timely payments on your credit report.
Weddings, vacations and the like. Many sources will encourage taking out a personal loan to finance a wedding, but think twice before borrowing for your nuptials, next summer’s family vacation, or other one-time "experience" buys. The rationale? These are short-term purchases that only create more debt. Using a personal loan for longer-term financial scenarios, like paying down debt or home improvements, are the more practical options, since the former is about improving credit in the near future; the latter, increasing equity.
Remember that personal loans are still debt. Using one to finance anything your heart desires, from a big-ticket purchase to an emergency expense, or towards debt, doesn’t ignore the fact that it’s still something you need to pay off. Follow these tips:
Don’t borrow more than you need. Even the lowest personal loan interest rates can be high, and may send you further into debt if your balance is hard to manage.
Practice good credit behavior. Don’t focus only on your personal loan. Incorporate it into your personal or family budget along with other bills, like your credit card or other expenses (like your mortgage or auto loan). Making a personal loan part of your revolving and installment debt, rather than the focal point, keeps your credit healthy.
Search for the right lender. See what kinds of personal loan offerings are at your local bank branch or credit union; nonprofit credit unions often provide lower interest rates. Check several online lenders, too, like Lending Club, Prosper or Earnest, marketplace-based lenders where money is funded by members and investors, not banks. It might be the answer to landing a personal loan with a lower interest rate you could have hoped for.
Image: Alfred Gescheidt (Getty)
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