A personal loan can be used for just about anything. Some lenders may ask what you plan to do with the money, but others will just want to be sure that you have the ability to pay it back. Though personal loans aren't inexpensive, they can be a viable option in a variety of circumstances. Here's how to decide if one is right for you.
- Personal loans can be used for almost any purpose.
- Unlike home mortgages and car loans, personal loans are usually not secured by collateral.
- Personal loans can be less expensive than credit cards and some other types of loans but more expensive than others.
How Personal Loans Work
Some kinds of loans are earmarked for a specific purchase. You can buy a home with a mortgage, purchase a car with an auto loan, and pay for college with a student loan. With a mortgage, your home serves as the collateral. Similarly, with an auto loan, the car you're buying will be the collateral.
But a personal loan often has no collateral. Because it is unsecured by property that the lender could seize if you default on the loan, the lender is taking a greater risk and will most likely charge you a higher interest rate than it would with a mortgage or car loan. Just how high your rate will be can depend on a number of factors, including your credit score and debt-to-income ratio.
Secured personal loans are also available in some cases. The collateral might be your bank account, car, or other property. A secured personal loan may be easier to qualify for and carry a somewhat lower interest rate than an unsecured one. As with any other secured loan, you may lose your collateral if you are unable to keep up with the payments.
Even with an unsecured personal loan, of course, failing to make timely payments can be harmful to your credit score and severely limit your ability to obtain credit in the future. FICO, the company behind the most widely used credit score, says that your payment history is the single most important factor in its formula, accounting for 35% of your credit score.
When to Consider a Personal Loan
Before you opt for a personal loan, you'll want to consider whether there may be less expensive ways you could borrow. Some acceptable reasons for choosing a personal loan are:
- You don't have and couldn't qualify for a low-interest credit card.
- The credit limits on your credit cards don't meet your current borrowing needs.
- A personal loan is your least expensive borrowing option.
- You don't have any collateral to offer.
You might also consider a personal loan if you need to borrow for a fairly short and well-defined period of time. Personal loans typically run from 12 to 60 months. So, for example, if you have a lump sum of money due to you in two years but not enough cash flow in the meantime, a two-year personal loan could be a way to bridge that gap.
Here, for example, are five circumstances when a personal loan might make sense.
1. Consolidating Credit Card Debt
If you owe a substantial balance on one or more credit cards with high interest rates, taking out a personal loan to pay them off could save you money. For example, as of this writing, the average interest rate on a credit card is 19.24%, while the average rate on a personal loan is 9.41%. That difference should allow you to pay the balance down faster and pay less interest in total. Plus, it's easier to keep track of and pay off a single debt obligation rather than multiple ones.
However, a personal loan is not your only option. Instead, you might be able to transfer your balances to a new credit card with a lower interest rate, if you qualify. Some balance transfer offers even waive the interest for a promotional period of six months or more.
2. Paying Off Other High-Interest Debts
Though a personal loan is more expensive than some other types of loans, it isn't necessarily the most expensive. If you have a payday loan, for example, it is likely to carry a far higher interest rate than a personal loan from a bank. Similarly, if you have an older personal loan with a higher interest rate than you would qualify for today, replacing it with a new loan could save you some money. Before you do, however, be sure to find out whether there's a prepayment penalty on the old loan or application or origination fees on the new one. Those fees can sometimes be substantial.
3. Financing a Home Improvement or Big Purchase
If you're buying new appliances, installing a new furnace, or making another major purchase, taking out a personal loan could be cheaper than financing through the seller or putting the bill on a credit card. However, if you have any equity built up in your home, a home-equity loan or home-equity line of credit could be less expensive still. Of course, those are both secured debts, so you'll be putting your home on the line.
4. Paying for a Major Life Event
As with any major purchase, financing an expensive event, such as a bar or bat mitzvah, a major milestone anniversary party, or a wedding, could be less expensive if you pay for it with a personal loan rather than a credit card. As important as these events are, you might also think about scaling back somewhat if it means going into debt for years to come. For that same reason, borrowing to fund a vacation may not be a great idea, unless it's the trip of a lifetime.
A personal loan can help improve your credit score if you make all your payments on time. Otherwise, it will hurt your score.
5. Improving Your Credit Score
Taking out a personal loan and paying it off in a timely manner could help improve your credit score, especially if you have a history of missed payments on other debts. If your credit report shows mostly credit card debt, adding a personal loan might also help your “credit mix.” Having different types of loans, and showing that you can handle them responsibly, is considered a plus for your score.
That said, borrowing money you don't really need in the hope of improving your credit score is a dangerous proposition. Better to keep paying all your other bills on time while also trying to maintain a low credit utilization ratio (the amount of credit you are using at any given time compared with the amount that's available to you).
The Bottom Line
Personal loans can be useful given the right circumstances. But they aren't cheap, and there are often better alternatives. If you're considering one, Investopedia's personal loan calculator can help you figure out what it would cost you.