Personal loans are unsecured, nonrevolving debts that aren’t tied to a specific purchase (like a car or a house). While their interest rates tend to be higher than home or auto loans, they’re almost always lower than credit card rates, especially if you have good credit.
People looking to consolidate or refinance high–interest rate debt often turn to personal loans, and that can make good sense financially. However, there are times when taking out a personal loan can do more harm than good to your finances, especially if you don’t have excellent credit.
Before you start a loan application, carefully consider your reason for borrowing this money, whether your budget can manage the monthly payments, and how the extra interest charges will affect your financial situation.
What is a personal loan?
A personal loan is a type of credit consumers can obtain and use for almost any purpose. Personal loans aren’t restricted to a particular purpose, unlike mortgages and auto loans.
When you apply for a personal loan, you’ll receive a lump sum of cash that you repay in fixed monthly installments until the loan term expires.
When Personal Loans Make Sense
Personal loans may make sense when they cost less than the alternative, as long as you can afford to pay them back on schedule. For example, a $5,000 personal loan at 5 percent might make more sense than putting $5,000 on an 18 percent credit card.
Along with the interest on the loan, you may also have to pay origination or loan-processing fees; those can range from 2 to 6 percent of the total amount you’re borrowing and add to the total cost of the loan.
1. Refinance High-Interest Debt
Personal loans can make sense when you have high-interest debt, such as credit card debt or payday loans. When the personal loan comes with a lower interest rate than your other debt and you can pay off the balance within a reasonable time period (no longer than five years; three is better), you can save thousands of dollars in interest.
However, the money-saving effects of the personal loan disappear if, for example, you continue to use credit cards without paying them off in full every month.
You can also use personal loans to consolidate several high-interest debts into a single loan with a lower interest rate. This makes it easier to track your debt and make sure that you’re never late with a payment.
2. Home improvement
A personal loan can be an excellent choice for home improvement projects, especially if the project adds value to your home. This prevents you from accruing credit card debt or pledging your house as collateral for a home equity loan.
Bad Reasons to Take Out Personal Loans
Using personal loans as a shortcut to saving up money can take a huge toll on your finances. When you spend the loan proceeds on discretionary purchases and nonessentials, those purchases will end up costing much more money.
It may be tempting to borrow money for a dream vacation or a wedding, but you will save thousands of dollars by saving up for big purchases (making monthly payments to yourself before the purchase rather than monthly payments plus interest afterward).
People also commonly use personal loans for paying medical bills, but they’re usually not the least expensive option (details on other options come later in this chapter).
For example, most doctors’ offices and hospitals offer payment plans, often with no or very low-interest charges. Dedicated medical credit cards may also be a better option than personal loans, as long as you fully understand their terms and conditions.
How to get a personal loan
Before you can apply for a personal loan, your credit score needs to be checked. Based on your credit score, you will know whether you are creditworthy or not.
Next, you need to figure out how much you need to borrow along with an estimated interest rate. The information you receive can help you pre-qualify, get a sneak peek at what you may receive from a lender, and compare the rates offered by online lenders, banks, and credit unions.
Consider other credit options such as 0%-interest credit cards, secured loans, or adding a co-signer. If you are considering a financing option, read the fine print to see if there are any fees. Also, know whether the lender offers features such as direct payments to creditors or flexible payment terms.
When you decide to proceed, gather the required documents so that you are prepared to apply formally for the loan.
Use Caution With Personal Loans
For people with poor credit, the interest rates on personal loans can run higher than credit card rates. When you google rate comparisons online, the rates you’ll see are normally the lowest rates the lenders offer—the ones they charge borrowers with good credit.
Make sure you know the rate you’ll get before you make a decision about the loan. Many personal loans also come with prepayment penalties, which kick in if you try to pay the loan off early. These penalties can be quite high; they’re meant to discourage you from paying ahead of schedule, which is normally much better for your financial situation.
Most important, the world of online personal loans is full of scammers and unscrupulous lenders whose aim is to take advantage of people in desperate financial situations.
Steer Clear of No-Check Loans
Instant, no-credit-check personal loans can seem like the answer to a prayer when you’re burdened by a huge debt, like a pile of medical bills, and have bad credit. Unfortunately, these easy-access loans can destroy your finances and pull you even deeper into debt.
You can find personal loans like these online with a quick Google search, and the results will include dodgy lenders that specifically target people who are desperate for quick cash. No-credit-check loans can come with enormously high APRs (a mix of interest and fees), sometimes even higher than 400 percent.
These are normally short-term loans (no more than three months), but that crazy high APR can make them very difficult to pay back. And even when you pay on time, you could end up paying three or four times as much as you originally borrowed.
Find a Reputable Lender
There are reasonable personal loans available even for people with bad credit (these are not the same as no-credit-check loans). If you decide to take out a personal loan, take the time to find a reputable lender.
You won’t get instant access to the loan proceeds, but you’ll usually have the money within a week. Your regular bank or credit union should be your first stop, especially if you’re a long-time customer. They may be willing to work with you even when your credit isn’t good.
If you don’t have a relationship with a bank already, do some online research to find lenders offering interest rates no higher than 36 percent and reasonable loan fees. Compare multiple lenders and loans to find the best deal you can get.
LendingClub or Prosper. Before you agree to any loan, make sure you understand all of the loan terms, especially the APR and loan repayment period. If you feel confused, pressured, or uncertain, take a step back and do some more research.