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March 5, 2023

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When Are Personal Loans a A Good Idea?

They’re not cheap however, they’re often your best option

By Tim Parker

Updated November 12, 2021

The review was written by Janet Ber-Johnson.

A personal loan can be used to pay for just about anything. Some lenders may ask what you intend doing with your money while others want to be sure that you have the ability to pay it back. Although personal loans aren’t cheap however, they are a viable option in a variety of circumstances. This article will help you decide if one is right for you.

Key Takeaways

Personal loans are a great option for almost any purpose.

In contrast to home mortgages and car loans however, personal loans generally aren’t secured by collateral.

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

What are the Personal Loans and how they work

Some types of loans are earmarked to be used for specific purchases. You can buy a home with a mortgage, purchase automobiles with an auto loan or take out an undergraduate loan. If you have a mortgage, your house serves as the collateral. Similarly, with an auto loan, the car you purchase will serve as the collateral.

But the personal loan typically does not have collateral. Because it’s secured by the property which the lender can seize in case you default on the loan the lender is taking a greater risk and will 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 number of factors, including your credit score and debt-to-income ratio.1

Personal Factors affecting the Interest Rate of a Loan

Investopedia / Lara Antal

Secured personal loans are also available in some cases. The collateral might be your bank account, your car or any other asset. A secured personal loan may be easier to obtain and has a somewhat lower interest rate than an unsecured loan. Similar to the other types of secure loan, you may lose your collateral if not able to make the monthly payments.

Even with a personal loan, of course, failing to make timely payments can be harmful to your credit score, and may hinder your ability to get loans in the near future. FICO, the company behind the most widely used credit score, says that your history of payments is the most significant element in their formula, accounting for 35 percent of your credit score.2

What are the best times to consider a personal Loan

Before you opt for an individual loan, you’ll want to look at alternatives that are less costly to borrow. The most acceptable reasons to consider for a personal loan include:

You don’t have and couldn’t qualify for a low-interest credit card.

The credit limits of your credit cards aren’t sufficient to provide the current amount of borrowing you require.

An individual loan is your least expensive borrowing option.

You don’t have any collateral to offer.

You may also think about the possibility of a personal loan in the event that you have to borrow over a short and well-defined period of time. Personal loans typically run between 12 and 60 months.3 Therefore, for instance in the event that you are facing an amount in one lump due 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.

For instance, here are five scenarios where the personal loan could be a good idea.

1. Consolidating Credit Card Debt

If you are owed a significant sum due to one or several credit cards that have very high rates of interest, getting a personal loan to pay off the debt could help you save cash. For example, as of this writing, the median interest rate on a credit card is 19.49 percent, whereas the typical 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. Additionally, it’s simpler to track and pay off a single debt obligation rather than multiple ones.

However, taking out a personal loan is not the only choice. You may be eligible to transfer your balances to a different credit card with lower rates of interest depending on whether you are eligible. Certain balance transfer deals waive the interest for an extended period of promotion that lasts for six months or more.

2. Repaying other high-interest debts

Although the individual loan is more expensive than some other types of loans, it isn’t necessarily the most expensive. If you’re in possession of an payday loan, for example it’s likely to carry a far higher interest rate than the personal loan from a bank. Also, if you’re carrying an older personal loan that has a higher interest rate than you would qualify for then replacing it with an entirely new loan could help you save money. Before you do, however, be sure to check if there is a penalty for prepayment on the original loan or any application or origination fees for the new one. Those fees can sometimes be significant.

3. Finance a Home Improvement or Big Purchase

If you’re purchasing new appliances, replacing a furnace, or making a significant purchase, taking out an individual loan is more affordable than financing through the seller or placing the purchase on a credit card. If you do have any equity built up in your home, a home-equity loan or a home equity line of credit could be less expensive still. Of course, those are both secured, so you’ll be putting your house on the line.

4. The cost of an Major Life Event

Like every major purchase, financing a high-cost event, such as the bat or bar mitzvah, an important anniversary celebration or a wedding may be less costly If you can pay for the occasion by using a personal loan rather than a credit card. According to a survey in 2021 conducted by Brides and Investopedia, one of five U.S. couples will use loans or investments to to pay for their wedding. As important as these events are, you may consider reducing the amount some if it means you’ll be into debt for a long time to come. In the same way, borrowing to fund a vacation may not be a great ideaunless it’s a holiday of an lifetime.4

A personal loan can help improve your credit score if you are able to make every payment on time. Otherwise, it will harm your credit score.

5. Enhancing Your Credit Score

Taking out a personal loan and paying it off in a timely manner could increase your score on credit, particularly if you have an occurrence of late payments on other loans. When your report reveals a lot of credit card debt, then taking out the personal loan could also improve to improve your “credit mix.” A variety of loans and showing you’re able to handle them with care is considered to be a positive for your score.5

That said, borrowing money that you don’t need in hopes of improving the credit rating of yours is a risky option. It’s better to continue paying all other bills on time and also trying to maintain the lowest percentage of credit usage (the sum of your credit you are currently using compared with the amount that’s available).

The Bottom Line

Personal loans can be beneficial in the right circumstances. However, they’re not cheap however, and there are usually more suitable alternatives. If you’re thinking about one, the Investopedia personal loan calculator can help you figure out what it would cost you.

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