Should I Get a Personal Loan?
A personal loan can be a valuable financial tool in many different circumstances. It can help you finance major purchases, cover unexpected expenses, or pay down debt at advantageous interest rates. However, if they’re not properly managed, personal loans can also lead to major financial woes.
This guide will explain everything you need to know about personal loans, including what they are, why people use them, and how to use them safely and responsibly. It will also highlight situations in which taking out a personal loan might not be the wisest course of action, and offer wiser alternatives that protect your long-term financial interests.
What Is a Personal Loan?
A personal loan is a form of credit extended by a lender to a borrower. In a typical case, a borrower will request a specific amount of money and submit an application for the lender to review. If the lender approves the application, the lending institution will forward the loan amount to the borrower in a lump sum. The borrower then becomes responsible for repaying that sum, with interest, in regular instalments until the debt is cleared.
Features of Personal Loans
Personal loans come in two main types: secured and unsecured. Secured loans require the borrower to offer some type of asset as collateral. The financial institution will claim the asset if the borrower fails to repay the loan. Unsecured loans, which most borrowers prefer, do not require any such consideration. Instead, borrowers qualify by meeting the lender’s credit rating and proof of income standards.
All personal loans share three common features:
- Principal: This is the amount of money the lender distributes in a lump sum when the loan originates.
- Interest: The interest rate is usually expressed as an “annual percentage rate” (APR), which expresses the percentage of the principal that will accrue each year in interest charges.
- Loan term: The term specifies the amount of time (in weeks or months) that you have to repay the loan.
Some loans also charge borrowers an origination fee, which supplements interest as a type of compensation earned by the lender. Origination fees are usually expressed as a percentage of the loan principal. Not all loans and lenders charge them, but you should watch for ones that do as these fees can have a major impact on the lifetime cost of your loan.
You should also be aware of any fees and charges your lender may apply to loans you pay off early. Repaying a loan ahead of schedule denies the lender some of the interest they would otherwise have earned on the debt, which is why lenders sometimes add early termination fees. Similarly, you could incur penalties for late or missed payments. These stipulations will be specified in your loan’s terms and conditions, so ask the lender if they apply or consult your loan documents.
What Is a Good Time to Take out a Personal Loan?
While lenders may ask you how you plan to use the money, personal loans do not usually come with restrictions. You are free to assign the funding to any legal purpose you deem necessary.
That said, there are some common situations that prompt borrowers to take out personal loans. In some cases, a personal loan may offer financial advantages that make them a particularly good idea. Here are some examples:
- Consolidating credit card debt: If you’ve got a credit rating that’s above average or better, chances are you can get a personal loan at a lower interest rate than what your credit card charges. Thus, personal loans can be a great debt consolidation tool: borrow the amount you owe your other creditors, pay off the high-interest debts, then pay down the lower-interest loan in monthly instalments. This strategy could save you hundreds or thousands of dollars.
- Refinancing student debt: Similarly, student loans frequently carry higher interest rates than comparable personal loans. However, remember that you enjoy some tax breaks by carrying student loan debt. You should take these advantages into careful consideration if you want to take out a personal loan as a way of paying back the money you borrowed for school.
- Financing a major purchase: People rarely pay cash for major purchases like new kitchen appliances, living room sets, home theater systems, or vehicles. Vendors and dealers often offer financing to qualified buyers, but if you shop around, you may find that a personal loan offers a better deal.
- Home improvements: While you won’t actually pocket any profits until you sell your home, using a personal loan to finance a renovation project that will raise your home’s resale value can be a very good investment.
- Boosting your credit score: Personal loans may improve your credit rating in many ways. For example, they differentiate the type of debt you’re carrying, so if you have nothing but credit cards, personal loans add the kind of variety lenders like to see.
Because your credit rating will go up if you pay back the loan promptly without missing any payments, and because loans can also reduce your overall credit utilization ratio, many consumers use personal loans as a means of improving their credit scores.
When Is a Personal Loan a Bad Idea?
Personal loans make less sense in other situations. Finance experts usually recommend avoiding them if you need the money for:
- Discretionary purchases: As a general rule of thumb, use personal loans to pay for things you “need” rather than things you “want.” Borrowing money for inessential and discretionary items can land you in a heap of debt trouble.
- Medical bills: Most healthcare providers offer payment plans with better financing terms than you would get by taking out a personal loan. You can also apply for specialized medical credit cards, which also tend to deliver significant savings compared to the cost of a loan.
- Investing: Using loan money to play the markets is something most personal finance experts advise against. Loan interest erodes any profits you might earn, forcing you to make risky moves to earn enough returns to make the investment worthwhile. This can be a recipe for disaster if the market goes against you.
If you decide that a personal loan is right for your situation, take your time to research the industry’s many lenders. Online personal loan companies offer a vastly expanded range of options beyond traditional banks and credit unions. Thanks to this hyper-competitive landscape, borrowers with a solid income and good credit ratings can shop around for highly advantageous terms.