How to Decide if a Personal Loan Is Right for You: Understanding Benefits and Risks
A personal loan is a helpful tool to pay for large purchases, recover from a financial crisis or cover emergency expenses. While personal loans may be the best option for your circumstances, they can also be an expensive borrowing choice. To help you determine if a personal loan is for you, learn more about the benefits and risks, considerations and best time to opt for one, as well as other financial options, such as credit cards, that may fit your needs.
7 Reasons Why People Take Out Personal Loans
The personal loan market continues to grow annually. Overall, the total personal loan debt in the U.S. reached $323 billion in 2020. In comparison, that is 6% or $18 billion more than 2019.
If you are considering taking out a personal loan to pay off debt, go on vacation or complete a home renovation project, but you’re not sure if it’s your best option, take time to consider your circumstances. You can also explore the seven reasons why individuals decide to get personal loans to learn more about how they can benefit certain financial situations.
One of the most common reasons why people take on a personal loan is to consolidate their pre-existing debts. By doing this, the loan pays off other loans or credit card debts. This financial strategy will help combine outstanding balances into one payment and can help reduce interest costs.
Pay off high-interest debts
While personal loans can be more expensive compared to other types of loans, there are still higher interest rate loans, such as payday loans. By getting a personal loan to replace an older personal loan with high interest, you can save money. Make sure you understand all fees involved, as well.
Start a business
Starting a business often requires some financing. A personal loan may be the right choice for you in this case. Aside from being less expensive, it may also be easier to qualify for personal loans for business. You can borrow from a bank, lender or credit union.
Some people begin their investment journey by taking out a personal loan. While this can be risky, it can help build your portfolio. You can use personal loans for stocks, mutual funds and even real estate. It’s important to consider how much you can afford to borrow and factor in the interest rates you're offered.
There are various emergencies that require an immediate influx of cash. Some of these may include medical bills and funeral costs, which can cost thousands of dollars. For many individuals, getting a personal loan is an affordable option for unforeseen expenses.
Finance a large one-off purchase
There are individuals who use personal loans to finance major one-off purchases. This could be due to low credit limits, vendors not accepting credit cards or qualifying for a lower interest rate. Many one-off purchases often include appliances, vacation expenses, purchasing a vehicle and home renovation projects.
Undergo a major life change
Major life events, such as a wedding, moving to a new home, starting college, going through a divorce or changing careers, come with financial costs. Personal loans can be helpful in these situations and help borrowers pay off large expenses over time.
Personal Loans Benefits and Risks
It’s important to consider your circumstances, needs, finances and budget before determining that a personal loan is the best option for you. While there are many pros to taking out a personal loan, you should be aware of the drawbacks. Before you apply, it’s advisable to weigh the benefits and risks of personal loans.
Benefits of Personal Loans
Personal loans can be exactly what you need for certain financial needs and offer you an affordable and flexible option. Learn more about some of the top benefits of personal loans.
While there are many specific loans available to consumers today, a personal loan can be used in many different ways. It can be a great option for debt consolidation, paying off medical bills and emergency expenses, starting a business, financing an investment and making a major purchase. In this way, how you use a personal loan is quite flexible and a benefit when it comes to your needs.
Lower Interest Rates
Generally, personal loans have lower interest rates compared to credit cards. The average personal loan rate is 9.39% in the third quarter of 2021, according to the Federal Reserve data. Meanwhile, the average credit card rate is 17.13%. Depending on your credit history and score, you may also qualify for even lower interest rates. Additionally, personal loans may also offer higher borrowing limits compared to your credit card.
You can get unsecured personal loans, which do not require collateral for approval. That means you can get a loan without needing to guarantee it with a large asset, such as your home or car. However, you will still have to repay your loan based on the agreed upon terms with the lender. If you fail to do so, you will face serious financial consequences.
Individuals needing immediate access to cash can benefit from personal loans. There are streamlined application and processing options available and some lenders even offer next-day funding. That said, it is important to research the loan, terms, lender, fees and other relevant information prior to applying.
Easy to Manage
Another benefit of getting a personal loan is that you can consolidate your debts, making it easier to manage your payments. In most cases, personal loans have fixed interest rates and repayment schedules are set. This can help you plan your monthly budget. However, you may also find one with a variable interest rate.
Risks of Personal Loans
Taking advantage of the benefits of personal loans can help you deal with your financial needs. However, it is important to remember that loans come with risks. Consider these before you decide to move forward in the application process.
High Interest Charges
While there are personal loans with low interest rates, there are also those with higher interest charges. Depending on your creditworthiness, you may find better deals by getting home equity loans, student loans or credit cards with 0% annual percentage rate (APR). Lenders may view personal loans as riskier investments since there is no collateral involved.
Fees and Penalties
Lenders may also charge certain fees, including those for applying and processing. Additionally, you may be charged with penalties if you make late payments or have insufficient funds to cover your payment. There are also lenders that charge prepayment penalties. It is essential you consider all the additional fees and possible penalties as they may increase payment costs.
Personal loans are not for everyone. Depending on the reason, you may end up with unnecessary debt. After all, a loan is borrowed money. You will have to pay it back with interest. So, before committing, you should evaluate your circumstances, calculate your debt-to-income ratio and assess if a personal loan is the best solution.
A personal loan application may involve a hard inquiry, which means the lender or institution will request to review your credit report. Such requests are recorded on your report and may have an impact on your credit score. Additionally, making late payments or missing a payment can lower your credit score.
You will need to pay for the amount of your personal loan plus interest based on the set rate. Additionally, you will need to plan for monthly payments. For some people, having a fixed payment schedule is hard. You must ensure you can pay for the loan before you even apply for one.
What You Need to Consider Before Getting Your First Personal Loan
Before applying for your first personal loan, it’s important to review your personal financial profile and current budget. Additionally, you should know your credit score and history, since lenders factor your creditworthiness and on-time payments history when reviewing your loan application. You should also determine if you could afford the monthly payment based on your current income.
To ensure you’re ready to take on a personal loan, ask yourself the following questions before applying for one.
Where will you use the loan?
Do you really need the loan or not? Where are you going to use it? Will it be for debt consolidation or emergency expenses? Do you need the money immediately? Or, can you wait for a while? It’s important to review these questions to help you assess your needs and possible other financial options.
How much loan do I need?
Determine how much money you need. Then, consider the amount you are qualified to borrow. Remember, the less money you owe, the less you will spend on interest.
What is the interest rate?
The interest rate will determine how much money you will end up paying monthly. Remember, if the rate is high, you will end up impacting your overall budget and could create a tight financial situation and debt you cannot afford to take on.
What type of personal loan is right for you?
In most cases, personal loans are unsecured. That means there is no collateral necessary to guarantee them. However, there are some different options to consider. The first is a fixed-rate personal loan, where the interest rate and monthly payment remain the same throughout the life of the loan. There’s also an adjustable-rate/variable personal loan, where the interest rate may change over time.
Are there alternatives?
You may find other lending options are better suited for circumstances. For example, if you need to cover an urgent expense and can pay back the total amount in a couple of months, a credit card may be a better option than a personal loan. Low-interest balance transfer cards and home equity loans may be other possible alternatives to personal loans.
How to Choose the Right Personal Loan
Whatever your reasons for taking out a personal loan, it is important to consider the implications of borrowing money. Additionally, you should also make sure you are getting the right loan based on your situation. The following tips could help you find the best personal loan for your needs.
- Compare interest rates. Lenders and institutions charge different interest rates for personal loans. To find the best loan option, comparing interest rates from multiple lenders is a good place to start. You will notice some are more affordable than others. You can research companies via their website and explore their comparison tools if available.
- Check fees, charges and penalties. Aside from interest rates, you should also compare the various lender fees. The most common include processing fees, late payment fees, loan cancellation fees, service tax and check bounce charges. You may also find special or limited offers, such as discounts on certain fees.
- Confirm the requirements. Find out if you are eligible for a personal loan through the lender you’ve chosen. The eligibility requirements may vary depending on the lender. You may find information on the lender’s website or contact their customer service hotline for more information.
- Be wary of predatory lenders. When looking for the right personal loan, it is crucial to research prospective lenders. You can start by finding reputable lenders and read reviews from previous clients. Be cautious of questionable offers and deals. Generally, if the deal is too good to be true, then it may be and you should investigate other options.
Should You Get a Personal Loan?
For some, a personal loan is a better option than a credit card. However, they may not be for everyone. Ensuring that a personal loan is the right decision is an important step. It’s necessary to know when a personal loan makes sense and when another option may be best. This can help you prevent a financial misstep.
When Should You Take Out a Personal Loan?
There's a variety of reasons consumers get a personal loan. Unlike other types of loans, there is no specific purpose for a personal loan. Therefore, it’s important to identify when a personal loan is the best option for your situation.
You want to consolidate your high-interest debt.
Consolidating your high-interest debt so that you will only have a single payment at a potentially lower interest rate could be a good reason to take out a personal loan. This can also ensure you are focused on paying down your debt faster while eliminating additional interest payments.
You have a major expense.
You can get a personal loan to take care of various expenses. For major expenses, such as purchasing a car or home or getting appliances and furniture, a personal loan may be a helpful tool.
You need funds for an emergency.
Personal loans can be useful during an urgent financial need. This may be ideal for medical bills, funeral expenses or unforseen and immediate large expenses.
You want to improve your credit score.
If you get a personal loan and consistently make on time payments, it can help boost your creditworthiness over time.
When Should You Avoid a Personal Loan?
For some people, a personal loan can lead to unnecessary debt. That is why it is important to weigh the pros and cons before you make your decision. The following circumstances should be considered before you take out a personal loan.
You cannot afford getting a loan.
A personal loan will need to be paid back, typically starting 30-days after taking it out. Therefore, it’s important to assess your budget to ensure you can afford the monthly payments. It may be better to not take on additional debt with a personal loan unless you absolutely need the funds.
You have other options.
The best type of loan is the one that fits your needs. If you have better options, then a personal loan may not be the right choice. For example, if you are in need of money for home renovation or repairs, a home equity loan may be better.
You are getting it for something you do not really need.
The reason you’re opting to take out a personal loan is one of the most important considerations. Ask yourself some important questions: Do you need the expense? Can it be paid for in another way? For example, if the cost of a vacation is too high, it may be best to wait until you can afford it and not take out a personal loan to cover the expense.
Learn the Types and Differences With Other Borrowing Option
There are various types of personal loans and each one fits a different circumstance. Knowing the differences between personal loan types and how they compare with other borrowing options can help you decide your best borrowing course of action.
Understanding Personal Loans Types
Knowing the different types of personal loans — unsecured, secured, fixed-rate and variable-rate, consolidated, co-sign and personal line of credit — can help you find the right option for your needs and situation.
Unsecured Personal Loans
In most cases, personal loans are unsecured. That means they are not guaranteed by collateral, such as your car or home title. Because of this, lenders consider unsecured personal loans riskier and tend to charge higher APRs. The approval of a loan application, as well as the APR, is based on the person’s creditworthiness.
Secured Personal Loans
There are also cases when a personal loan is secured, which means collateral is involved. Some lenders require an asset to serve as a guarantee for a loan. In comparison, secured personal loans typically have lower interest rates than unsecured loans. That is because lenders consider borrowers with collateral as less risky.
Usually, personal loans are fixed-rate loans. That means your interest rate and monthly debt obligation, which are also known as installments, remain the same for the life of the loan. A fixed-rate loan is best for individuals who want consistent monthly payments and are concerned about rising interest rates.
You can also get a variable-rate personal loan. Unlike fixed-rate loans, this type of loan includes a changing interest rate based on the fluctuations in the benchmark rate. That means your monthly payment and interest costs may vary. Typically, variable-rate loans have lower APRs than fixed-rate loans. It may be a good option for loans with short repayment terms.
Debt Consolidation Loans
If you want to roll multiple debts into a single loan, then debt consolidation loans are for you. It helps simplify debt payments by combining debts into fixed monthly payments. This type of loan usually has a lower APR than the rates of existing debts. This can help you save money on interest.
Individuals with no credit history or poor credit scores may find it hard to qualify for a loan. Finding a co-signer who will promise to make the repayment if the borrower does not can help. The co-signer serves as insurance for the lender. Having a co-signer with excellent credit can help increase the likelihood of getting approval for a loan and may help you get a lower interest rate.
Personal Line of Credit
Similar to a credit card, a personal line of credit may be a good option for your needs. Instead of a lump sum of cash, the borrower can access a credit line and borrow funds as they need. Additionally, borrowers only pay interest on the amount used. This type of loan is good for those needing a loan for emergencies, one-time expenses or ongoing expenses.
An Overview of Different Ways to Borrow Money
There are multiple ways to borrow funds when you need them and personal loans are just one option. Keep in mind, the best type of loan is the one that is not only affordable, but it suits your needs. Explore other borrowing options available to you below.
A mortgage can help you pay for your home. But it can also be helpful even if you already own your home. You can get a second mortgage so that you can borrow a large amount of money. A second mortgage will be paid back monthly and may be subject to low-interest rates.
Credit Card Advance
If you need a short-term loan, you can take out a cash advance on your credit card. Instead of using your card to pay for a purchase or service, take it to your bank or an ATM and withdraw your cash advance.
If you own a vehicle, you could use its title to get a loan. Title loans are short-term loans that usually last 15 to 30 days. You can get around 25% to 50% of your car’s value by using it as a collateral.
Another type of short-term loan is a payday loan. These are typically small loans, $500 or less, and are repaid within two to four weeks at a higher interest rate.
Bank overdrafts are short-term loans banks offer to certain clients whose payment exceeds their account balance. In such a case, funds are deducted from the account holder’s account. Not all bank clients will qualify for an overdraft and they come with specific conditions.
Pawn Shop Loans
You can get a loan by offering personal property and items as collateral, such as electronics and jewelry. The pawn shop will provide the loan with set repayment terms. The borrower has to repay the loan on time to get back their property or they may lose it to the pawn shop to sell as they see fit.
Retirement Funds or Insurance
Some individuals use their retirement funds or life insurance policies to get funds. Simply put: you will be borrowing money from yourself. This can be a less stressful borrower option; however, failure to repay the loan may result in negative tax consequences.
Family and Friends
An informal way of getting a personal loan is to borrow funds from family or friends. Depending on the agreement, you may borrow a set amount and repay on agreed upon terms, without interest or fees. However, if you miss payments or fail to repay the amount in full, it can harm or end your relationship.
Expert Insight on Determining if a Personal Loan Is the Right Option
There are many factors and concepts to consider when learning about personal loans. MoneyGeek spoke with industry leaders for their expert insights to help you determine whether a personal loan is the right option for you.
- What do you think is the most important thing people need to know when it comes to personal loans?
- Do you have any tips to help people properly manage their personal loans?
Education Manager at Debt Reduction Services, Inc.
CEO of DebtHammer
Certified Educator in Personal Finance and Owner & Executive Director at Healthy Rich
Resources on Personal Loans and Other Options
Finding in-depth and reputable resources can help you better understand loans, borrowing options and their guidelines, benefits and risks. Explore the following resources to expand your knowledge and help you make wise financial decisions.
- Banks: Your financial institution can be a good place to start when exploring your financial options. You can talk to a representative to learn about their loan opportunities, terms, fees and interest rates.
- Federal Student Aid: This data center can help you find information about federal financial assistance programs specifically made for students or students’ families.
- Federal Trade Commission (FTC): Learn more about your rights as a consumer and know how to report frauds or similar criminal activities. You can also get information about different types of loans.
- GovLoans.gov: This is an online resource to help individuals looking for government loans. Find loans you are eligible for in a variety of categories.
- Kabbage: This online financial technology company helps small businesses get direct funding through an automated lending platform.
- MyCreditUnion.gov: Use the credit union locator to find a credit union near you. You can also access free financial calculators and explore relevant publications and articles.
- National Association of Student Financial Aid Administrators: Get access to different financial aid resources for students. You can find data on the state level or national level and about post-secondary research organizations.
- Personal Loans USA: This company connects borrowers to lenders. You only need to submit a loan request and wait for lenders to contact you.
- Prosper: If you are looking for peer-to-peer lending, Prosper is the right place. It is a marketplace where people can invest in each other.
- Small Business Administration: SBA can help you get a loan for your small business by setting guidelines for loans made by partnering lenders, community development organizations and micro-lending institutions.
- USA.gov: Learn more about different government programs to help people in need of financial assistance. You can search for available government grants and loans, as well as the requirements.
- U.S. Department of Housing and Urban Development: Learn more about Federal Housing Administration (FHA) loans. This is best for people buying their first home or those looking for apartments.
About the Author
- Experian. "Growth of Personal Loan Debt Slows Amid Pandemic." Accessed January 10, 2022.
- Federal Trade Commission. "Consumer Information: What To Know About Payday and Car Title Loans." Accessed January 10, 2022.
- Federal Reserve. "Consumer Credit - G.19." Accessed February 2, 2022.