February 5, 2023

Good Reasons to Get a Personal Loan – and Times You Should Avoid One

A personal loan allows you to borrow a lump sum of money, in some cases up to $100,000, that you usually repay over a period of one to five years. The interest rate and monthly payments on a personal loan are typically fixed, which means you know exactly how much you owe each month and how long it will take to repay the loan.

But just because you can technically use a personal loan to pay for a vacation – or even buy a luxury handbag – doesn’t mean you should. Here are some situations when borrowing a personal loan can be a smart financial move, as well as when you should avoid one.

Good Reasons to Get a Personal Loan

When used wisely, a personal loan can help you meet your financial goals such as getting out of debt or remodeling your kitchen. Personal loans can also give you fast access to cash if you need to cover an emergency expense – often at a lower interest rate than you would find with a credit card. And since personal loan interest is typically fixed instead of variable, your monthly payments will stay the same during a set repayment term.

Given the benefits listed above, here are a few good ways to use a personal loan.

You Can Pay Off Credit Card Debt at a Lower Interest Rate

Personal loans are often used to refinance credit card debt at a lower, fixed interest rate. Compared with making the minimum monthly payments on credit card debt, personal loans can help you pay off your balance faster and save money on interest over time.

Whereas credit card interest is compounded daily, personal loans have simple interest – meaning the interest you pay is calculated on the principal balance only. This saves you money and makes it easier to estimate how much you’ll pay in interest charges during the life of the loan.

Take this example: If you make the $300 minimum monthly payment on $10,000 worth of credit card debt at a 23.99% annual percentage rate, you’ll pay more than $6,600 in interest alone over 56 months before you’re debt-free. By comparison, if you borrow a 48-month personal loan of the same amount at a 15% interest rate, you’ll pay about $3,360 in interest – all while lowering your monthly payment to $278. In this case, you can save nearly $3,300 and get out of debt eight months faster with credit card refinancing.

Personal loans can also be used to combine the balances of several credit cards into a single monthly payment, which can streamline the debt repayment process. You may even see an improvement to your credit score, since you’re reducing your credit utilization to zero and improving your mix of credit accounts. Just be careful not to rack up more credit card debt while you repay your personal loan.

You Want to Consolidate Multiple Types of High-Interest Debt

Personal loans can be used to repay virtually any type of debt, not just credit cards. You can consolidate payday loans; car title loans; pawnshop loans; buy now, pay later loans; and even other personal loans into a debt consolidation loan at a lower interest rate.

A $300 payday loan with a fee of $15 per $100 borrowed may not seem expensive at first. But if you can’t repay the loan at the end of the two-week period and you need to roll it over, you’ll have to pay the $45 fee again – and the cycle repeats until the loan is repaid. This is equivalent to an APR of nearly 400%, according to the Consumer Financial Protection Bureau. Further CFPB research shows that the typical car title loan carries around a 300% APR, and pawnshop loan APRs can exceed 200%.

Balance/Loan Amount Fees/APR Monthly Payment Repayment Length Fees/Interest Paid
Rewards Credit Card $2,570 21% $80 4 years $1,238
Store Credit Card $635 24% $25 3 years $260
Payday Loan $300 $45 every two weeks $190* 3 months $270
HVAC Loan $10,000 18% $210 7 years $7,655

*Average spent per month for a total payment of $570.

You’d end up juggling four payments that amount to $505 each month, all while paying nearly $9,500 in interest alone before all the debts are repaid. But if you consolidated all these debts into a three-year personal loan at a 16.5% interest rate, you’d have a single monthly payment of $478, and you’d save more than $5,700 on interest and fees during the course of repayment.

If you’re looking to consolidate these debts into a lower monthly payment, you could potentially opt for a longer-term personal loan. This would result in less total interest savings – but with a competitive rate, you could significantly reduce your payment amount while still saving money over time.

You Want to Finance Home Improvements Without Tapping Equity

Unlike other financing tools such as home equity loans or lines of credit, personal loans don’t use your home as collateral. This can make them a better option if you don’t have sufficient equity in your home or if you don’t want to risk losing the roof over your head if you can’t make payments. And while home equity loans and HELOCs can take a month or longer to go through the closing process, personal loan funding is much quicker.

Importantly, though, personal loans will typically have higher interest rates than home equity loans or HELOCs, making them more expensive to repay over time. But if you have excellent credit and can qualify for a low-interest personal loan, or if you only need to borrow a small amount of cash, a personal loan can be a suitable alternative to tapping your home’s equity.

You Need Quick Cash During an Emergency

When you need money for an emergency expense such as a car repair or a new refrigerator, but you don’t have enough money to cover it with cash or savings alone, a personal loan can be a viable option. As you can see in the examples above, alternative financing services such as payday loans can be an expensive way to cover an unexpected bill, and swiping your variable-rate credit card may not be much better.

Personal loans offer the benefit of fast access to a lump sum of cash at a fixed interest rate. The application process is relatively quick: You can typically find out if you’re approved on the same day you apply, and funding takes anywhere from one to seven days after approval. Some online lenders even offer same-day funding, so you can get the money you need as soon as possible.

If you’re not sure whether to borrow a personal loan in an emergency, you can usually get prequalified to view your estimated terms with a soft credit check. That way, you can determine whether the interest rate is competitive, the monthly payments are affordable and the loan amount can cover your expense. Keep in mind that not all personal loan companies let you get prequalified without damaging your credit score, so read the fine print before filling out the inquiry form.

Still, there may be better borrowing options than personal loans if you just need cash to cover an expense.

When to Avoid Using a Personal Loan

Borrowing an unsecured personal loan isn’t always a smart financial move. Remember that taking out a personal loan will add to your overall debt load, add another monthly payment to your budget and cost you money in interest over time. Here are a few instances when you shouldn’t use a personal loan, as well as the alternatives to personal loans in these circumstances.

You Can’t Qualify for a Good Rate

Personal loan interest rates can be as high as 36%, which can make them more expensive than most other borrowing options, particularly secured loans. Applicants with fair or bad credit will generally see much higher interest rates than those with good credit. Some lenders also charge a loan origination fee, typically around 1% to 5% of the loan amount.

Alternative: Work on building your credit before applying, or enlist the help of a creditworthy co-signer such as a trusted relative or friend. You could also look into your local credit union for small-dollar loans. When compared with traditional banks and lenders, credit unions can offer more favorable terms for their members with a less-established credit history – because while most financial institutions are for-profit companies, credit unions are nonprofit and member-owned.

You Can’t Afford the Monthly Payments

Personal loans can offer a short-term solution if you need quick cash to cover an emergency, but they can become a long-term burden if you can’t keep up with the monthly payments. Missing personal loan payments can leave a negative mark on your credit report, and long periods of delinquency may lead to more serious consequences.

Alternative: Dip into your emergency fund if you have one – that’s what it’s there for, after all. If you need money in a pinch but you don’t have enough cash reserves, you could potentially look into borrowing from a family member. And if you need money to cover necessary expenses such as groceries, utility bills or child care, you may qualify for aid through your local social services office or food pantry.

You Plan on Using the Funds for Discretionary Spending

Just because personal loans can be used to pay for virtually any expense doesn’t mean it’s a good idea to borrow one. You should generally avoid taking out any type of debt – including credit card debt – for discretionary purchases. If you want to pay for a vacation or even a wedding, it’s better to save up for months (or years) in advance.

Alternative: Create a savings plan by calculating how much money you need to cover the expense, and keep dividing that number until you get to a monthly payment you can afford. Automate your savings by allocating a monthly contribution amount that’s withdrawn from your paycheck via direct deposit. And with a high-yield savings account, you can boost your savings fund with compound interest.

You Need to Pay for a Medical Expense

Personal loans are often used to pay for medical expenses, but you should explore your other repayment options before taking out a medical loan. Borrowing a personal loan for medical bills will leave you repaying your health care costs, plus interest, for years to come.

Alternative: Many health care providers offer no-interest or low-interest payment agreements with more favorable repayment terms than you’d find with a loan. You may also be able to negotiate medical bills for less than you owe or find the procedure you need at a lower cost through another provider. Additionally, nonprofit hospitals are required by federal law to establish a financial assistance policy for low-income patients, although the specific legislation varies by state.

You Can Find Better Terms Elsewhere

Depending on your reason for borrowing a personal loan, you may be able to find a cheaper financing option. Because your interest rate is the financing cost of a loan, a lower rate amounts to less money paid to the bank over the life of the loan. Even if you have good credit, it’s best to shop around for the lowest rate among a variety of loan products when you need to borrow money.

Alternative: A HELOC can be a lower-interest borrowing tool for home improvements, especially if you have a significant amount of tappable equity in your home. If you have very good or excellent credit, you may be able to qualify for a 0% APR credit card promotion to cover an emergency expense. And when it comes to debt consolidation, using a credit card balance transfer may also offer better terms than a personal loan.

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