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When are personal loans a good idea?

They’re not cheap however, they’re often the best choice.

By Tim Parker

Updated 12 November 2021

Reviewed by Janet Berry-Johnson

A personal loan can be used to pay for any purpose. Some lenders might ask you what you’re planning to do with the money however, others require proof that you’re able to pay back the loan. Although personal loans aren’t cheap but they are an option that is feasible in a variety of circumstances. Here’s how to decide whether one is the best option for you.

Key Takeaways

Personal loans can be used for almost any purpose.

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

Personal loans can be less expensive than credit cards and some other kinds of loans but more expensive than others.

How do personal loans work?

Some types of loans are earmarked for a specific purchase. It is possible to purchase a home using a mortgage, buy automobiles using an auto loan, and make payments for college using an undergraduate loan. When you take out mortgages, your home is used as collateral. In the same way, when you take out an auto loan the vehicle you purchase will serve as the collateral.

But a personal loan typically does not have collateral. Because it’s secured by the property which the lender may seize should you fail to pay the loan, the lender takes on a greater risk and will most likely charge you a higher rate of interest than for a mortgage or a car loan. The amount you pay will be is contingent on a variety of variables, including your credit score and debt-to-income ratio.1

Personal Loan Interest Rate Factors

Investopedia / Lara Antal

Secured personal loans are also possible in certain instances. The collateral could be your bank account, your car, or other property. A secured personal loan may be easier to obtain and has some of the lowest interest rates than an unsecured one. Like any other secured loan it is possible to lose your collateral if in a position to not make the monthly payments.

However, even with a personal loan Of course the inability to make timely payments could be detrimental to your credit score and could hinder your ability to get loans in the near future. FICO is the company that created the most popular credit score, says that your history of payments is the single most important element in their formula, accounting for around 35 percent of the credit score.2

What are the best times to consider a personal Loan

Before you decide to take out the personal loan it is important to look at less expensive ways you could take out a loan. The most acceptable reasons to consider for a personal loan include:

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

The credit limits of your credit cards aren’t sufficient to meet your current borrowing needs.

A personal loan is your least expensive borrowing option.

There is no collateral to offer.

You may also think about the possibility of a personal loan in the event that you have to borrow for a fairly short and well-defined period of time. Personal loans typically range from 12 to 60 months.3 For instance when you have a lump sum of money due to you in two years but not enough cash flow during that time A two-year personal loan may be a viable option to fill in the gap.

Here, for example, are five scenarios where an individual loan could be a good idea.

1. Consolidating Credit Card Debt

If you are owed a significant amount due to one or several credit cards that have higher interest, taking out a personal loan to pay them off could save you money. As an example, at this moment, the average interest rate on credit cards is 19.49%, while the rate for personal loan is 9.41%.1 The difference in rates should enable you to pay down the balance faster and pay less interest in total. It’s also easier to monitor and pay off one debt, rather than several ones.

However, a personal loan is not your only choice. Instead, you might be able to transfer your balances onto a new credit card with a lower interest rate depending on whether you are eligible. Certain balance transfer deals offer a no-interest period for the duration of at least six months.

2. Repaying other high-interest debts

Although the personal loan is more expensive than other kinds of loans however, it’s not necessarily the most expensive. If you’re in possession of an payday loan, for example it will likely have a much higher interest rate than the personal loan from banks. If you also have an older personal loan that has a higher interest rate than you would qualify for, replacing it with the new loan can save you money. However, before you make the switch, be sure to find out whether there’s a prepayment penalty on the original loan or if there are origination or application fees on the new one. The fees may be substantial.

3. The financing of a home Improvement or Big Purchase

If you’re looking to purchase new appliances, installing a brand new furnace, or making another important purchase, getting personal loan may be less expensive than financing with a seller or putting the bill on a credit card. However, if you have any equity on your property, taking out a home-equity loan or a home equity line of credit might be more affordable. Of course, these are both secured loans, so you’ll be putting your house on the line.

4. Paying for a Major Life Event

Similar to any big purchase, financing an expensive occasion, like an event like a bat or bar mitzvah, a major milestone anniversary party, or a wedding, could be less expensive if you pay for the event by using a personal loan instead of a credit card. According to a survey in 2021 conducted by Brides and Investopedia, one out of five U.S. couples will use loans or investments to pay for their wedding. While these weddings are important, as they are, you might consider reducing the amount some if it means you’ll be into debt for years to be. In the same way, taking out a loan to pay for a vacation might not be the best idea, unless it’s the trip of the lifetime.4

A personal loan can help improve your credit score if you make all your payments on time. In the absence of this, it can affect your credit score.

5. Improve Your Credit Score

Taking out a personal loan and paying it back on time can help improve the credit rating of your, especially if you have a history of missed payments on other loans. When your report is mostly credit card debt, then taking out the personal loan could also improve your «credit mixture.» Having different types of loans and proving that you’re able to handle them with care is considered to be an advantage for your score.5

However, taking out loans for money you don’t really need to improve you credit standing is a dangerous proposition. Better to keep paying your autres bills in time while also trying to maintain a low percent of your credit’s utilization (the sum of your credit you are using at any given time in comparison to the credit that’s available).

The Bottom Line

Personal loans are a good option if they’re in the right circumstances. They’re expensive however, and there are usually better alternatives. If you’re considering one, the personal loan calculator can help you figure out what it would cost you.

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