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Understanding the pros and cons of personal loans is important when shopping for a lender and deciding whether or not to apply for financing. Although personal loans can be useful in many situations, they can also come with high interest rates and major repercussions on your credit score. Even so, the benefits of these loans may outweigh the risks, especially if you qualify for a competitive rate and need quick access to cash.
Whatever your situation, here are some tips to help you navigate this borrowing decision.
What is the benefit of getting a personal loan?
Personal loans can be a great option if you want to consolidate high-interest debt or if you need cash for a home improvement project or other major expenses that you can afford to pay back. Not only are most personal loans unsecured, meaning the lender doesn’t require collateral, but many come with competitive interest rates and zero fees.
Still, there are some downsides to taking out a personal loan, so it’s important to assess your needs as well as the pros and cons of the personal loan before borrowing.
Advantages of Personal Loans
Personal loans can be extremely beneficial under the right circumstances. Personal loans can be advantageous because they can:
1. Help borrowers build credit
Taking out a personal loan requires making regular monthly payments on the outstanding balance. Lenders typically report your payment history to the three major credit bureaus: Equifax, Experian, and TransUnion.
If you regularly make on-time payments, it can help boost your credit score. payment history represents 35% of your FICO credit score. It also means you can damage your score if you make late or default payments, making it harder to access credit in the future.
2. Let borrowers pay for purchases over time
Lenders pay out personal loans as a lump sum that you can use to make a purchase or pay off other debt. This allows borrowers to make large purchases and pay them off over time, without saving money up front. While this can be a good strategy for necessary purchases, it can become dangerous if you rely on loans to go on vacation or cover other discretionary expenses.
3. Make debt consolidation easier
Debt consolidation loans allow borrowers to streamline their finances by paying off individual loans and credit card balances with one personal loan. Not only does this reduce the number of payments you need to remember each month, but it can also lead to a lower overall interest rate if your credit score has improved since you took out your other loans.
Some lenders specialize in debt consolidation and will pay off your other debts directly instead of disbursing money to your account.
Related: Advantages and disadvantages of debt consolidation
4. Be used for almost everything
Personal loans are a popular financing option because they’re so versatile, and you can use them to cover everything from car repair costs to home improvements and event-related expenses, like weddings.
Acceptable uses of loans vary by lender, but most institutions allow borrowers to use the funds for personal, family, or household purposes. Personal loans cannot be used to pursue illegal activities. Some lenders also limit the use of personal loan funds to purchase real estate, pay for post-secondary education, or start a new business.
Related: 6 good reasons to get a personal loan
5. Offer competitive rates
Annual Personal Loan Percentage Rates (APR) typically range from 3% to 36%, with the most competitive rates reserved for highly qualified applicants. Although the upper range of rates can be high, many applicants qualify for a lower APR than that available with a standard credit card. However, these rates are still higher than secured loans like home equity loans.
If you’re considering getting a personal loan, take the time to prequalify with top lenders to see what kind of rates you’re likely to get.
Related: What is a good interest rate on a personal loan?
6. Provide flexible borrowing limits
Borrowing limits vary by lender, but personal loans are generally available between $1,000 and $100,000. For this reason, personal loans can be tailored to meet the borrowing needs of most consumers. Remember that getting a $100,000 personal loan will likely be more difficult than qualifying for a smaller, less risky sum. Alternatively, if you’re considering financing a smaller purchase, credit card or point-of-sale financing may be the best option.
7. Eliminate the need for collateral
Most personal loans do not require the borrower to post collateral. This means you won’t have to risk losing a valuable asset, like your home or car, if you don’t repay the loan. However, keep in mind that unsecured loans usually come with higher interest rates and may be more difficult to obtain as they pose more risk to lenders.
8. Provide quick access to cash
Personal loan and financing application processing times vary, but many lenders advertise same-day or next-day financing. So, if you face unexpected car repair costs or emergency travel needs, a personal loan may be an option.
However, if you need funds quickly, consider the entire loan application process carefully. The actual time it takes to apply, get approved, and receive loan funds may be longer depending on when you apply, the size of the loan, and how quickly your bank allows you access. to the money after it is disbursed.
Disadvantages of personal loans
Loans can be a great way to cover expenses, but there are also risks and drawbacks to taking out a personal loan. Before borrowing, consider that personal loans can:
1. Accumulate high interest charges
While the most creditworthy personal loan applicants may benefit from low annual interest rates, others may encounter higher rates of up to 36%. Depending on your loan offer, this rate can be much higher than rates available through other types of financing, such as home equity loans, home equity lines of credit (HELOCs), student loans and credit cards at 0% APR. Consider all alternatives to personal loans before signing on the dotted line.
2. Come with fees and penalties
In addition to interest rates, many lenders charge an application fee and origination fee to cover processing costs. Likewise, a borrower may incur penalties for making a late payment or having insufficient funds for payment. Some institutions also impose prepayment penalties, although the most competitive lenders do not. When shopping for a personal loan, keep an eye out for additional fees and penalties that can increase the cost of borrowing over the life of the loan.
3. Lead to credit damage
Just as lenders report positive payment history to credit bureaus, they also report late payments and non-payments. Because of this, borrowers who don’t make payments on time — or who don’t fully repay the loan — risk ending up with a lower credit score. Additionally, taking out a personal loan increases the borrower’s balance, which is 30% of your FICO credit score.
4. Require guarantees
If you don’t have a high enough credit score to qualify for a secured loan, you may need to pledge assets as collateral. This is most often the case with applicants who have a FICO credit score below around 585. In the case of a secured personal loan, the lender can retain the security in the event of default. Common collateral includes assets such as a borrower’s home, car, boat or certificate of deposit (CD).
5. Lead to unnecessary debt
Depending on why you took out a personal loan, this type of financing can lead to unnecessary debt. Before committing to a loan, large or small, assess why you are borrowing the funds and whether a personal loan is the best solution.
Is the personal loan for you?
A personal loan may be right for you if:
- You have a high credit score and will help qualify for a low interest rate
- There is room in your budget for a new monthly payment
- You want to consolidate several debts with high interest rates
- Your debt-to-income ratio (DTI) is 36% or less
- You will not qualify for a 0% APR credit card
- You are tackling a project that will add value to your home