Pros & Cons of Personal Loans: Key Things to Know

A personal loan is an amount of money borrowed from banks or financial institutions. It can typically be used for any purpose, so long as the borrower can repay the amount borrowed with interest in monthly installments for a set time.

Personal loans are like other forms of debt, with benefits and drawbacks. If you use them wisely, personal loans can help you improve your credit score and reach financial goals. Left unchecked, however, you may face financial challenges.

Understanding the pros and cons of personal loans can help you determine if they’re the right financial tool for you and make wise financial decisions.

The benefits of a personal loan often give it advantages over other loans or lines of credit. In the right circumstances, getting a personal loan can help you reach a financial goal or improve your overall credit score.

Some loans can only be used for a particular purpose, such as auto loans to finance cars or student loans for education. On the other hand, personal loans can be used for any purpose.

For instance, you can use a personal loan for a home renovation project, medical bills and more. Essentially, you can use a personal loan to pay off significant purchases over time if you cannot save in advance.

Personal loans have an average rate of 9.41%, which is much lower than a credit card’s average rate of 14.56%. Lenders will likely give you more favorable rates if you have a high credit score.

Aside from competitive interest rates, the advantage of personal loans is that some lenders offer a choice between fixed and variable rates. A fixed interest rate means you will pay the same monthly payment throughout the life of the loan, while a variable interest rate means your payment amount can rise or fall depending on the lender’s benchmark rate or index.

One of the benefits of personal loans is their flexibility. Aside from having lower interest rates, a personal loan often has higher borrowing limits than other sources like credit cards. With a personal loan, you can finance high-cost projects, like renovating your kitchen or consolidating debt.

However, keep in mind that lenders determine your borrowing limits based on your creditworthiness and income. Lenders will likely offer you a higher borrowing amount if you have good credit and a decent income threshold.

Collateral is an asset used as security for a loan, which the lender can take should the borrower default on payments. Collateral is typically used for secured loans, like auto loans or mortgages. However, personal loans can also be unsecured, requiring no collateral.

An unsecured personal loan can be advantageous for borrowers who do not want to put their assets on the line. Instead of using collateral as the basis of approval, lenders look at a borrower’s financial picture. This includes looking at their credit history, proof of income, debt-to-income (DTI) ratio and more.

Lenders require that borrowers make regular, monthly payments towards their outstanding personal loan balances. These periodic payments can go a long way in improving your credit score, with payment history and on-time payments accounting for 35% of your FICO score.

Conversely, late payments or a default on payments can harm your score. Borrowers who plan to get a personal loan should ensure they can meet the payment requirements.

The process of applying for a personal loan and the funding time will vary from lender to lender. Still, most lenders who offer online applications boast a decision-making time of 24 to 72 hours. Some lenders even offer funds the next day, with others providing funds in less than a week.

Applying for a personal loan is easy, as the requirements are relatively straightforward. While actual documentation requirements can vary based on the lender, most financial institutions will ask for a completed application form, proof of identity, income verification and proof of address.

Personal loans have terms that are easier to manage than credit cards or payday loans. For instance, terms can range from 24 to 60 months, and some lenders are willing to extend the repayment period.

Aside from having long periods, repayment schedules are reasonably straightforward, requiring a monthly payment that can be fixed for the life of the loan.

While personal loans can be helpful in many situations, not all borrowers may benefit from them. Understanding the risks of a personal loan is crucial before applying for one, as a loan’s usefulness often hinges on a borrower’s unique financial circumstances.

Many lenders charge fees to process and issue a loan, including application fees and origination fees. Typically, fees have to be paid before getting a loan, meaning you can end up paying a fee and have your application denied.

You could also face a few penalty fees, such as late payment fees, early repayment penalties or returned check fees. For instance, if you decide to pay off your loan early, the lender may charge an early repayment penalty as it can no longer receive interest on the loan.

While these are small fees in the face of the interest you will pay over time, they can increase the actual cost of borrowing.

While a personal loan can be helpful, it is a form of debt and can increase your overall debt burden over time. If you do not monitor your spending habits, you can find yourself in more debt than when you started, especially if you use the funds to finance purchases instead of consolidating debt.

While the interest rates for personal loans are, on average, lower than those of credit cards, the monthly repayment amounts may be higher. Unlike credit cards, which are revolving, personal loans need to be repaid by the end of their term. For this reason, it’s vital for you to know how much you can handle in monthly payments before applying.

One of the risks of personal loans is that low interest rates are not guaranteed. While personal loans typically have lower interest rates than credit cards, lenders base rates on a borrower’s creditworthiness. This involves looking at your credit score, income and debt-to-income ratio. If you have a low credit score, you are likely to have high interest rates compared to other types of financing.

Like any financing option, personal loans can affect your credit. In the application stage, lenders will conduct a hard inquiry into your credit history, which is a non-negotiable part of the process and can impact your score negatively, albeit temporarily.

It’s a good idea to choose wisely and prequalify if possible to avoid multiple hard credit checks from different lenders within a short time.

Banks and financial institutions also report a borrower’s payment history to credit bureaus. On-time payments can build a positive credit score, while the opposite can lower it. If you miss or default on payments, your credit score may decrease.

There are two types of personal loans: secured and unsecured. Unsecured loans require no collateral, while secured loans do. Borrowers with poor credit scores may be compelled to pledge an asset to get a personal loan.

Assets that can be used as collateral include real estate, vehicles, insurance policies or other high-value items equal to the desired borrowing amount. Backing your loan with an asset puts your ownership of that asset at risk, as financial institutions are legally allowed to seize it if you default on payments.

Personal loans often come with a fixed payment schedule, as they have to be repaid, with interest, in a specific period. While this can be beneficial for those who are prepared, failing to meet the fixed payment requirements can result in a lender seizing your collateral or taking legal action. That said, if you are the type of borrower who prefers to pay on your own terms, you may want to opt for a different financing option instead.

It’s important to understand the benefits and risks of a personal loan prior to applying for one. Generally, a personal loan makes sense in the following situations:

• If you want to consolidate multiple, high-interest debts.
• If you need money quickly, such as for emergencies.
• If you have a good credit score and can get favorable rates from lenders.
• If you need to fund a major expense, such as a home renovation project.
• If you want to improve your credit score and can afford the monthly payments.

Knowing the pros and cons of personal loans is essential, as applying for a loan is a big financial commitment. Review a few commonly asked questions about personal loans below.