A personal loan can be used for just about anything. Some lenders may ask you what you plan to do with the money, but others will just want to be sure that you have the capacity to pay it back. Although personal loans are not cheap, they can be a viable option in a variety of circumstances. Here’s how to decide if this one is right for you.
Key points to remember
- Personal loans can be used for almost any purpose.
- Unlike mortgages and auto loans, personal loans are generally not backed by collateral.
- Personal loans can be cheaper than credit cards and some other types of loans, but more expensive than others.
How personal loans work
Certain types of loans are intended for a specific purchase. You can buy a house with a mortgage, buy a car with an auto loan, and pay for your college education with a student loan. With a mortgage, your home serves as collateral. Likewise, with an auto loan, the car you buy will be the collateral.
But a personal loan often has no collateral. Because it is not guaranteed Per property that the lender could seize in the event of a default, the lender takes on a greater risk and will most likely charge you a higher interest rate than with a mortgage or car loan. The amount of your rate may depend on a number of factors, including your credit score and debt to income ratio.
Secured personal loans are also available in some cases. The collateral can be your bank account, your car or any other asset. A secured personal loan may be easier to obtain and have a slightly lower interest rate than an unsecured loan. As with any other secured loan, you risk losing your collateral if you fail to make the payments.
Even with an unsecured personal loan, of course, failure to make timely payments can hurt your credit score and significantly limit your ability to obtain credit in the future. FICO, the company behind the most used credit score, says your payment history is the most important factor in their formula, accounting for 35% of your credit score..
When to consider a personal loan
Before opting for a personal loan, you’ll want to consider whether there are cheaper ways to borrow. Here are some acceptable reasons for choosing a personal loan:
- You do not and cannot qualify for a low interest credit card.
- The credit limits on your credit cards are not sufficient to meet your current borrowing needs.
- A personal loan is your cheapest borrowing option.
- You have no guarantees to offer.
You can also consider a personal loan if you need to borrow for a fairly short and well-defined period. Personal loans generally last 12 to 60 months.So, for example, if you have a lump sum owed to you in two years, but not enough cash in the meantime, a two-year personal loan might be one way to bridge that gap..
Here are, for example, five circumstances in which a personal loan can make sense.
1. Credit card debt consolidation
If you owe a substantial balance on one or more high-interest credit cards, taking out a personal loan to pay them off could save you money. For example, at the time of this writing, the the average interest rate on a credit card is 19.24%, while the average rate for a personal loan is 9.41%.This difference should allow you to pay off the balance faster and pay less interest overall. In addition, it is easier to track and pay off a single debt rather than several.
However, a personal loan is not your only option. Instead, you might be able to transfer your balances to a new credit card with a lower interest rate, if you qualify. Some balance transfer offers even waive the interest for a promotional period of six months or more.
2. Repayment of other high interest debts
Although a personal loan is more expensive than some other types of loans, it is not necessarily the most expensive. If you have a payday loan, for example, it is likely to carry a much higher interest rate than a personal loan from a bank. Likewise, if you have an older personal loan with a higher interest rate than what you would be entitled to today, replacing it with a new loan could save you money. Before doing so, however, make sure you know if there is a prepayment penalty on the old loan or administrative fees or set-up costs on the new one. These fees can sometimes be significant.
3. Financing a home renovation or a large purchase
Whether you’re buying new appliances, installing a new furnace, or making another major purchase, taking out a personal loan might be cheaper than vendor financing or putting the bill on a credit card. However, if you have built up equity in your home, a Home equity loan or home equity line of credit could be even cheaper. Of course, these are two secured debts, so you are going to put your house in jeopardy.
4. Pay for a major event in life
As with a major purchase, financing an expensive event, like a bar or bat mitzvah, a major anniversary, or a wedding, can be less expensive if you do it with a personal loan rather than a credit card. As important as these events are, you might also think about cutting back a bit if that means going into debt for years to come. For that same reason, borrowing to finance a vacation might not be a good idea, unless it is the trip of a lifetime.
A personal loan can help you improve your credit score if you make all of your payments on time. Otherwise, it will hurt your score.
5. Improving your credit score
Taking out a personal loan and paying it off on time can improve your credit score, especially if you have a history of missed payments on other debts. If your credit report mostly shows credit card debt, adding a personal loan can also improve your “credit mix”. Having different types of loans and showing that you can handle them responsibly is considered a plus for your score.
That said, borrowing money that you don’t really need in the hope of improving your credit score is a dangerous proposition. Better to keep paying all your other bills on time, while trying to keep a low credit utilization ratio (the amount of credit you are using at any given time versus how much you have available).
The bottom line
Personal loans can be useful under the right circumstances. But they don’t come cheap, and there are often better alternatives. If you are considering one, Investopedia personal loan calculator can help you figure out what it would cost you.