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When Are Personal Loans a A Good Idea?

They can be expensive however, they’re often your best option

By Tim Parker

Updated November 12, 2021

The review was written by Janet Ber-Johnson.

A personal loan can be used for just about anything. Some lenders might ask you what you plan for the funds, but others will just need to know if you’re able to pay back the loan. Although personal loans aren’t inexpensive, they can be an option for you in many different situations. This article will help you decide which one is best for you.

The most important takeaways

Personal loans are a great option for almost any purpose.

Unlike home mortgages and car loans Personal loans generally aren’t secured by collateral.

Personal loans can be less expensive than credit cards and other kinds of loans but they can be more costly than others.

How do personal loans work?

Some kinds of loans are specifically arranged to be used for specific purchases. It is possible to purchase a home using a mortgage, buy automobiles using an auto loan, and take out the student loan. When you take out a mortgage, your home serves as the collateral. In the same way, when you take out an auto loan the vehicle you’re buying will be the collateral.

However, a personal loan usually does not require collateral. Because it’s secured by property that the lender could seize if you default on the loan the lender is taking a higher risk and will likely charge you a higher interest rate than it would with a mortgage or car loan. The amount you pay will be will depend on several factors that include your credit score and debt-to income ratio.1

Personal Factors affecting the Interest Rate of a Loan

Investopedia / Lara Antal

Personal loans are also available in some cases. The collateral could be your bank account, your car or another property. The secured personal loan may be easier to obtain and has some of the lowest interest rates than an unsecured one. As with the other types of secure loan it is possible to lose your collateral if unable to keep up with the payments.

However, even with a personal loan Naturally the inability to make timely payments can be harmful to your credit score and could hinder your ability to get loans in the near future. FICO the company behind the most frequently used credit score, states that your credit history is the primary aspect in its formula, which accounts for 35% in your credit score.2

What are the best times to consider a personal Loan

Before you decide to take out an individual loan it is important to think about alternatives that are less costly to borrow. Some acceptable reasons for choosing the 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 don’t provide the current amount of borrowing you require.

An individual loan is the least expensive borrowing option.

There is no collateral to provide.

You might also consider a personal loan if you need to borrow for a fairly brief and clearly defined period of duration. Personal loans generally range from 12 to 60 months.3 For instance in the event that you are facing a lump sum of money due in two years , but don’t have enough cash flow to cover it, a two-year personal loan could be a way to bridge that gap.

Here, for instance, are five situations where a personal loan might make sense.

1. Consolidating Credit Card Debt

If you owe a substantial sum for one of your credit cards with very high rates of interest, taking out an individual loan to pay these off could save you money. For example, as of this writing, the average interest rate for credit cards is 19.49 percent, while the average rate on a personal loan is 9.41%.1 That difference should allow you to pay off the debt quicker and pay less interest in total. Additionally, it’s simpler to track and pay off a single debt, rather than several ones.

But a personal loan is not your only choice. Instead, you might be able to transfer your balances onto a new credit card that has an interest rate that is lower If you meet the requirements. Certain balance transfer deals eliminate interest during the duration of at least six months.

2. Repaying other high-interest debts

Although the personal loan is more expensive than some other types of loans but it’s not the most costly. If you’re a holder of a payday loan, for example it’s likely to have a much higher interest rate than the personal loan from a bank. Similarly, if you have an old personal loan with a higher interest rate than you would qualify for today then replacing it with a new loan could help you save money. Before you do, however make sure you check if there’s a prepayment penalty on the old loan or any application or origination charges on the new loan. The fees may be substantial.

3. The financing of a home Improvement or major Purchase

If you’re looking to purchase new appliances, replacing a furnace, or are making another major purchase, taking out an individual loan is more affordable than financing with a seller or putting the bill on a credit card. However, if you have any equity built up on your property, taking out a home-equity loan or home equity line of credit might be less expensive still. Of course, those are both secured loans and you’ll be putting your house on the line.

4. The cost of the cost of Major Life Event

Similar to every big purchase, financing a high-cost occasion, like the bat or bar mitzvah, an important anniversary celebration or wedding may be less costly when you finance it with a personal loan instead of a credit card. According to a survey in 2021 by Brides and Investopedia, one of five U.S. couples will use loans or investments to help to pay for their wedding. As important as these events are, you might consider reducing the amount slightly if you’re going into debt for a long time to be. This is why borrowing to fund a vacation may not be a great option unless it’s the vacation of a lifetime.4

A personal loan could help boost your credit score, if you pay all your payments on time. Otherwise, it will hurt your score.

5. Improving Your Credit Score

A personal loan and repaying it on time can help improve your credit score, particularly if you have a history of missed payments on other debts. In the event that your credit score shows mostly credit card debt, then taking out the personal loan might also help to improve your “credit mix.” A variety of loans and proving that you can handle them responsibly, is considered a plus for your score.5

However, taking out loans for money you don’t really need in the hope of improving you credit standing is a risky option. It is better to pay your autres bills in time, while making sure you maintain a low percentage of credit usage (the amount of credit you are currently using in comparison to the credit that’s accessible to you).

The Bottom Line

Personal loans can be beneficial in the right conditions. They’re expensive however, and there are usually more suitable alternatives. If you’re considering one, the personal loan calculator will help you figure out what it would cost you.