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When Are Personal Loans a good idea?

They’re expensive however, they’re often the best choice.

By Tim Parker

Updated 12 November 2021

Review by Janet Berry-Johnson

A personal loan is a great option for just about anything. Some lenders may ask what you plan for the cash however, others want to be sure that you have the ability to pay back the loan. Although personal loans aren’t cheap however, they are an option for you in a variety of circumstances. Here’s how to decide if one is right for you.

Important Takeaways

Personal loans are a great option for almost any purpose.

Contrary to car loans however, personal loans typically are not secured by collateral.

Personal loans can be less expensive than credit cards and some other types of loans but more expensive than other types of loans.

What are the Personal Loans and how they work

Certain types of loans are earmarked to be used for specific purchases. You could buy a house using a mortgage, buy automobiles by using an auto loan, and pay for college with the student loan. With a mortgage, your home serves as the collateral. Similar to an auto loan the vehicle you purchase will serve as the collateral.

However, a personal loan typically does not have collateral. Because it’s secured by the property which the lender can seize in case you default on the loan the lender is taking on greater risk and will likely charge you a higher rate of interest than with a mortgage or car loan. How high the rate will be is contingent on a number of factors such as your credit score and debt-to-income ratio.1

Personal Loan Interest Rate Factors

Investopedia / Lara Antal

Personal secured loans are available in certain cases. The collateral could be your bank account, your car, or other property. Secured personal loan may be easier to get and have an interest rate that is lower than an unsecured loan. As with the other types of secure loan the risk of losing your collateral if in a position to not make the payments.

Even with an unsecured personal loan Of course failure to pay on time payments could be detrimental to your credit score and severely limit your ability to obtain credit in the future. FICO is the company that created the most frequently used credit score, says that your credit history is the most significant aspect in its formula, accounting for 35% of your credit score.2

When to Consider a Personal Loan

If you are considering a personal loan it is important to consider whether there may be alternatives that are less costly to take out the loan. The most acceptable reasons to consider for a personal loan include:

You don’t need and can’t be eligible for a low-interest credit card.

The credit limits on your credit cards do not provide the current amount of borrowing you require.

An individual loan is your least expensive borrowing option.

There is no collateral to provide.

You might also consider the possibility of a personal loan when you’re looking to borrow for a fairly brief and clearly defined period of time. Personal loans typically run between 12 and 60 months.3 Therefore, for instance in the event that you are facing a lump sum of money due in two years but not enough cash flow during that time the two-year personal loan could be a way to fill in the gap.

Here, for instance, are five situations where an individual loan could be beneficial.

1. Consolidating Credit Card Debt

If you are owed a significant sum on one or more credit cards with higher interest, taking out a personal loan to pay off the debt can save you money. For instance, as of this writing, the median interest rate for a credit card is 19.49%, while the typical rate on personal loan is 9.41%.1 The difference in rates should enable you to pay off the debt more quickly and pay less in interest over the course of. Plus, it’s easier to monitor and pay off a single debt, rather than several ones.

However, the personal loan is not the only choice. Instead, you might be capable of transferring your balances onto a new credit card with a lower interest rate If you meet the requirements. Certain balance transfer deals offer a no-interest period for a promotional period of six months or more.

2. In addition, you can pay off other debts with high interest rates.

Although a individual loan is more costly than other types of loans, it isn’t necessarily the most expensive. If you’re a holder of a payday loan, for example, it is likely to have a much higher interest rate than a personal loan from a bank. Also, if you’re carrying an older personal loan with a higher rate than what you’re eligible to receive today, replacing it with an entirely new loan can save you money. Before you do, however ensure you check if there’s a penalty for early payment on the original loan or if there are origination or application fees on the new one. These fees could be substantial.

3. The financing of a home Improvement or a Big Purchase

If you’re looking to purchase new appliances, replacing a furnace, or are making another major purchase, taking out personal loan may be less expensive than financing through the seller or placing the purchase on credit card. If you do have any equity built up within your house, then a home equity loan or home equity line of credit might be cheaper. Of course, they are both secured loans which means you’ll have to put your house on the line.

4. Paying for a Major Life Event

Similar to any major purchase, financing a costly occasion, like an event like a bat or bar mitzvah, a major milestone anniversary party or a wedding can be cheaper when you finance the event using personal loan rather than credit cards. According to a study in 2021 conducted by Brides and Investopedia, one in five U.S. couples will use loans or investments to finance their wedding. However important these occasions are, you may consider reducing the amount some if it means you’ll be in debt for years to be. For that same reason, taking out a loan to pay for a vacation isn’t a good option unless it’s the trip of an lifetime.4

A personal loan could help boost your credit score, if you pay your payments punctually. Otherwise, it will affect your credit score.

5. Improving Your Credit Score

The act of taking out a personal loan and paying it off on time can boost your score on credit, especially if you have an occurrence of late payments on other debts. When your report shows mostly the credit cards, adding the personal loan could also improve the “credit mixture.” A variety of loans and proving that you’re able to handle them with care, is considered a plus for your score.5

But, taking out a loan for funds you don’t really need to improve your credit score is a dangerous idea. It is better to pay all other bills on time while also trying to maintain the lowest percent of your credit’s utilization (the sum of your credit you are making use of at any time in comparison to the credit that’s available).

The Bottom Line

Personal loans are a good option if they’re in the right conditions. However, they’re not cheap and often there are better options. If you’re thinking of getting one, the personal loan calculator will help you determine how much it will cost you.