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When Are Personal Loans a good idea?

They’re expensive, but they’re sometimes the best choice.

By Tim Parker

Updated 12 November 2021

Reviewed by Janet Berry-Johnson

A personal loan can be used for almost anything. Some lenders will ask what you plan doing with your money however, others need to know if you’re able to repay it. Though personal loans aren’t inexpensive but they are a viable option in many different situations. Here’s how to decide if one is right for you.

Important Takeaways

Personal loans are a great option to serve almost any purpose.

Contrary to car loans however, personal loans generally aren’t secured with collateral.

Personal loans may be cheaper than credit cards and other types of loans but more expensive than other types of loans.

How Personal Loans Work

Certain types of loans are earmarked for a specific purchase. You could buy a house with a mortgage, purchase the car you want by using an auto loan or make payments for college using a student loan. If you have a mortgage, your home acts as collateral. Similarly, with an auto loan the car you buy will serve as your collateral.

But the personal loan often has no collateral. Because it is unsecured by property that the lender can seize in case you fail to pay the loan the lender is taking a greater risk and will most likely charge you a higher rate of interest than for a mortgage or a car loan. How high the rate will be is contingent on a number of factors that include your credit score as well as your debt-to-income ratio.1

Personal Credit Interest Rate Factors

Investopedia / Lara Antal

Secured personal loans are also available in some cases. The collateral could be your car, bank account or any other asset. A secured personal loan could be simpler to get and have a somewhat lower interest rate than an unsecured loan. Similar to every other type of secured loan, you may lose your collateral if you are unable to keep up with the repayments.

Even with an unsecured personal loan Naturally, failing to make timely payments could harm your credit score, and may hinder your ability to get credits in the future. FICO the company behind the most popular credit score, says that your payment history is the most significant element in their formula, which accounts for 35% of the credit score.2

What are the best times to consider a personal loan

Before you decide to take out the personal loan, you’ll want to think about alternatives that are less costly to take out the loan. Some acceptable reasons for choosing a personal loan include:

There is no way to qualify for a low-interest credit card.

The credit limits on your credit cards do not provide the current amount of borrowing you require.

A personal loan is your least expensive borrowing option.

You don’t have any collateral to offer.

It is also possible to consider a personal loan in the event that you have to borrow for a fairly limited and defined amount of time. Personal loans generally range between 12 and 60 months.3 Therefore, for instance, if you have an unpaid amount due to you in two years , but don’t have enough cash flow in the meantime, a two-year personal loan might be an option to fill in the gap.

Here, for instance, are five situations where an individual loan might make sense.

1. Consolidating Credit Card Debt

If you have a large balance due to one or several credit card with high interest rates, taking out a personal loan to pay these off could save you cash. For example, as of this writing, the average interest rate on credit cards is 19.49 percent, while the average rate on personal loan is 9.41%.1 The difference in rates should enable you to pay the balance down more quickly and pay less in interest over the course of. It’s also simpler to track and pay off a single debt obligation rather than multiple ones.

However, a personal loan is not the only choice. Instead, you might be capable of transferring your balances to a different credit card with an interest rate that is lower depending on whether you are eligible. Certain balance transfer deals waive the interest for the duration of at least six months.

2. Paying Off Other High-Interest Debts

While the individual loan is more expensive than other kinds of loans however, it’s not necessarily the most costly. If you have a payday loan, for example it will likely carry a far higher interest rate than the personal loan from the bank. Also, if you’re carrying an old personal loan with a higher interest rate than the one you qualify for then replacing it with the new loan could save you some money. Before you do, however ensure you check if there is a penalty for prepayment for the previous loan or application or origination charges on the new loan. The fees may be substantial.

3. Financing a Home Improvement or major Purchase

If you’re buying new appliances, installing a brand new furnace, or making another significant purchase, taking out a personal loan could be cheaper than financing with a seller or putting the bill on a credit card. If you do have any equity in your home, a homeowner equity loan or home-equity line of credit could be more affordable. Of course, those are both secured debts and you’ll be putting your house on the line.

4. Paying for an Major Life Event

Like every major purchase, financing a high-cost occasion, like a bar or bat mitzvah or a significant milestone anniversary party, or a wedding, could be less expensive when you finance the event by using a personal loan instead of credit cards. According to a 2021 survey by Brides and Investopedia, one out of five U.S. couples will use loans or investments to finance their wedding. As important as these events are, you might also think about scaling back some if it means you’ll be into debt for years to come. For that same reason, taking out a loan to pay for a vacation might not be the best ideaunless it’s a holiday of an lifetime.4

A personal loan will help you improve your credit score, if you pay your payments punctually. If not, it could affect your credit score.

5. Improve Your Credit Score

Taking out a personal loan and paying it off on time can help improve your score on credit, particularly if you have an occurrence of late payments on other loans. In the event that your credit score reveals a lot of credit card debt, obtaining a personal loan might also help the «credit mix.» The ability to have different kinds of loans, and showing that you can handle them responsibly is considered to be a positive for your score.5

That said, borrowing money you don’t really require in the hope of improving you credit standing is a risky proposition. Better to keep paying all autres bills in time and making sure you maintain the lowest percent of your credit’s utilization (the amount of credit you are using at any given time in comparison to the credit that’s accessible to you).

The Bottom Line

Personal loans can be useful given the right conditions. But they aren’t cheap and often there are more suitable alternatives. If you’re thinking about one, Investopedia’s personal loan calculator can help you determine what it will cost you.

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Article Sources

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