Personal loans can be taken out for almost anything: debt consolidation, medical bills, a skyrocketing wedding budget. It is this flexibility that makes personal loans both attractive and potentially dangerous to the borrower.
Whatever the reason for taking out a personal loan, if you don’t have a plan on how to repay it, you could be on thousands of dollars in high-yield debt. Late payment – or worse, a defaulted loan – could give you a bad rap with credit bureaus and make it difficult to one day take a credit card or rent an apartment.
Before you get a personal loan, ask yourself: can I afford to take on debt? Do I get the best deal? What would I give up if I took on debt? Would a loan be necessary now?
Here’s what you need to know about personal loans, and what you should or shouldn’t use it for.
What is a personal loan?
A personal loan, as the name suggests, is a fixed installment loan that gives you quick access to cash for personal use. Most personal loans are unsecured, which means they are not backed by collateral. Unsecured loans usually have higher interest rates than secured loans because they are riskier for the lender. However, since the borrower does not run the risk of losing their assets – like their home or car – if they default on their payments, unsecured loans are generally better for the borrower.
Aside from the basic restrictions imposed by your loan provider – many personal loan companies don’t allow their personal loans to be used for business, investment, real estate, or tuition – you can use a personal loan for almost anything. Some of the most common uses for personal loans are debt consolidation, home repairs, and emergency expenses. However, it is important to remember that while personal loans can give you access to easy money, it is nowhere near to being the case for free Money. Personal loan interest rates depend on your creditworthiness and loan terms and can get quite high for those with poor creditworthiness. Before you take out any personal loan, make sure that it is really necessary and that you have a repayment plan. And depending on your needs, it may be worth looking into alternative options like a prepaid credit card or a home loan.
When should I take out a personal loan?
Credit card debt consolidation is one of the most popular personal loan use cases. Anuj Nayar, Financial Health Officer at LendingClub, says, “When we started in 2008, we positioned ourselves as a better way to get credit for anything you wanted. It could be home improvement, vacation, whatever. We found that the vast majority of customers came to us for debt consolidation – and the vast majority of them were people looking to refinance credit cards to get back on the road to financial health. “
With an average APR of 15%, with some cards exceeding 25%, credit card debt can be expensive and overwhelming. It is a difficult treadmill to get off of, so personal loans can be beneficial. To pay off the debt, you borrow a fixed amount of money at a fixed interest rate and make a fixed monthly payment.
With proper budget planning and automated payments, managing personal loan debt can be easier than managing credit card debt, the interest rate of which is usually variable. For comparison: The interest rates for personal loans can be between 5% and 36% depending on creditworthiness and loan terms. But to be clear, since loan rates can easily exceed the rates on higher credit cards, this step only makes sense if you can get a personal loan with a lower interest rate than the APR on your credit card.
If you have good credit, a prepaid credit card may be an alternative worth considering. Certain cards offer 0% APR for an introductory period, usually 12 to 18 months, and allow you to transfer your existing balance from other cards for a one-time fee. If you want to consolidate credit card debt, a balance transfer card could serve as the counterpart to a personal loan with 0% interest, as long as you settle the balance before the introductory period ends. Otherwise, you will be hooked for high APRs from credit cards.
If you are having problems with debt management, we recommend that you contact your creditor first. Often times, lenders are willing to work with you during difficult times. Whether it’s deferring payments, negotiating a lower interest rate, a monthly payment, or waiving fees, getting accommodation from your lender will make it easier for you and your creditworthiness in the long run. You may also find help with free credit counseling services that won’t provide you with money directly but will help you get your finances in order.
Home improvement, be it a home renovation or repair, is another common reason to take out a personal loan. In the event of a leaky roof, termites, or supply issues, it may be advisable to take out a personal loan to cover the significant up-front costs and pay back the costs over time. However, if you are thinking of ripping out walls for an open floor plan or digging the back yard to build a pool, consider whether this is a big reason to potentially take on tens of thousands of debt and what a reasonable amount of loan would be.
“Don’t over-indebted,” says Farnoosh Torabi, financial journalist and presenter of the podcast “So Money”. “Any type of debt that you take on, especially a personal loan, shouldn’t make up more than 5 to 10% of your monthly budget.”
And here, too, it’s important to have a plan – and the funds – to pay back a loan, especially for unnecessary home repairs that could potentially be postponed for now. It may make more sense to take out a loan for a long-planned home repair if you have confidence in your financial stability in the near future.
If you need to borrow a large amount of home improvement loans, a home equity loan, line of credit line (HELOC), or cash out refinance may help you get higher loan values and better interest rates. These options allow you all to access your home equity for access to cash, but in different ways. Be aware, however, that they all require using your home as collateral, which can be riskier than an unsecured personal loan.
First of all, the Funeral Consumers Alliance, a not-for-profit consumer organization, does not recommend taking out a loan to finance a funeral, as these loans often come with high interest rates.
However, according to the National Funeral Directors Association, the average cost of a funeral in 2017 was $ 7,360. It’s an incredible amount of money for most people, but especially for those in the midst of grief for a loved one and perhaps navigating financial uncertainty elsewhere. When a funeral cannot be paid for out of pocket or with life insurance, surviving family members can consider a personal loan as a last resort.
We agree that funeral expenses personal loans should be the absolute last resort, but if you believe your circumstances require it, at the very least you should get credit estimates from multiple lenders to get an interest rate and term that is as little cause additional hardship on the line as possible.
When should I not take out a personal loan?
Couples spend an average of $ 30,000 on their wedding, according to the 2020 WeddingWire Newlywed Report. The cost has increased every year as nice things – like bridesmaid robes, wedding favors, and brunch the day after – turn into essential expenses. Many services such as catering and event venues automatically cost more once the word “wedding” is uttered. Hence, it is not a problem that people want to take out a personal loan to deal with the rising costs.
However, we don’t recommend taking on debt to pay for a wedding. Getting into $ 30,000 in debt at the start of a marriage will add unnecessary pressure to this new chapter in life and limit your ability to invest in a home, savings, or retirement account.
Some people use personal loans to pay for travel expenses, such as flights, hotels, and excursions, and to pay off debts in the months or years afterwards. Before you call your bank to get financing for a trip to Venice or Lake Tahoe, it is important to understand that these loans can be expensive and, if your credit is bad, they require high interest rates.
It can also be a rude awakening to come back from vacation with a big bill and not pay it back. LendingClub’s Nayar says personal loans are best used for emergencies or financial recovery, not “promoting an Instagram lifestyle.”
Instead, try to save for a vacation over a period of time, take advantage of flight and travel deals, and use credit card rewards points to earn cheap or free travel.
Personal loans can be used to consolidate all types of debt, including student loans (although some lenders have restrictions on this). However, it is generally not recommended unless you have a student loan with unusually high interest rates. Most student loans have lower interest rates than personal loans, and if you replace your student loan with a personal loan, you will lose access to deferrals, deferrals, and other types of payment arrangements. This is especially true if you have government student loans that offer a lot of protections that private lenders don’t.