Pros And Cons Of Personal Loans: Things You Need To Know
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Summary:
While personal loans can be a quick and easy way to secure funds, these loans have both pros and cons to keep in mind. But a personal loan may not be the best choice for everyone because they often come with application fees and origination fees. To qualify for the best interest rates and loan terms, you’ll also need a good credit score.
Personal loans definitely have their place and can be used for a number of purposes, like consolidating debt, paying off medical bills, or fixing up your home. Plus you can usually gain access to the funds in a short period of time, which can be great in an emergency. But personal loans aren’t appropriate for everyone’s situation.
“Personal loans offer versatility, allowing borrowers to use the funds for a variety of purposes. One of their advantages includes the predictability of monthly payments, which simplifies budgeting. Additionally, they typically do not require collateral,” says Brian Samelko, Head of Personal Lending at PNC Bank. “However, there are potential drawbacks, which may include lower loan amounts and higher interest rates compared to other secured loans.”
Read on to learn more about the pros and cons of personal loans, if a personal loan is right for you, and when an alternative solution might be a better answer to your situation.
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Advantages of personal loans
There are a lot of good reasons to take out a personal loan, such as when you need to finance a large purchase or pay off high-interest debt. Let’s take a closer look at some of the other advantages of taking out personal loans.
Better than credit cards
Most personal loans have better interest rates than credit cards, which can make them a less costly borrowing option. You also have the advantage of a fixed-rate monthly payment which can be easier to budget for than less predictable credit card payments.
It should be noted that personal loan rates aren’t as good as they are for secured loans. However, the better your credit score, the more likely you are to qualify for more competitive interest rates.
Build credit history
When you have a personal loan (or any kind of debt), personal loan lenders — like banks, credit unions, or other financial institutions — report your information to the three major credit bureaus (Experian, TransUnion, and Equifax). When you make consistent monthly payments that are on time and for the full amount, the positive payment history gets reported and will help to boost your credit score.
Payment history is the most heavily weighted element of your credit report that goes into calculating your score. In addition, if you only have revolving credit (like credit cards) on your report, adding an installment loan like a personal loan (or mortgage or car loan) to your credit mix can also raise your score.
Pro Tip
Keep in mind that if you do make late payments, miss a payment, or fail to repay your personal loan your credit history will suffer. That can make it much more difficult to qualify for loans or credit in the future.
Lump sum of money with flexible loan terms
When you take out personal loans, you’re typically given a lump sum of money that you can use to make a large purchase right away or pay off a debt. Personal loans also give you the flexibility to choose the loan term that’s right for you.
Loan terms typically run from two to five years, but you might qualify for extended loan terms. Because of this flexibility, you can essentially decide how much you can afford for a monthly payment and pick the loan term that corresponds to that.
Just be aware that if you’re borrowing money for only a short period of time, you’ll have higher monthly payments. This is great if you want to pay off the loan amount quickly and avoid paying a lot of interest. However, if you want smaller, more manageable monthly payments, you may want to choose a longer financing term.
Good way to consolidate debt
A debt consolidation loan is just another way of looking at a personal loan that’s meant to consolidate credit card debt into one easy payment. As mentioned, if you have good credit, you can get a better interest rate for personal loans than you would with credit cards which can save you a significant amount of money.
It’s also much easier to budget for the fixed-payment schedule that comes with a personal loan. That way, you don’t have to juggle multiple credit card monthly payments with various due dates.
High borrowing limits
Personal loan borrowing limits vary by lender but typically range anywhere from a couple of thousand dollars to $100,000. This means you may qualify for a larger loan amount than you could get with a credit card limit.
But don’t forget that the more money you borrow, the more debt you’re in and the more you’ll pay in interest over the life of the loan. To see what limit you may qualify for, take a look at the personal loan options below using our comparison tool.
Quick loan processing
Compared to some other loan products, getting qualified for a personal loan is a relatively quick and easy process. If you have a good income and a solid credit history, you could qualify for the personal loan and have the money in your bank account within days.
Don’t need collateral
Unsecured personal loans don’t require collateral. So if something happens and you can’t repay the loan, you don’t risk losing your assets. For example, with home equity loans or auto loans, if you fail to repay the loan, financial institutions can seize your home or car.
IMPORTANT! In some cases, like if you have a lower credit score or insufficient income, lenders may require you to put up some collateral or decline to approve your loan application.
Drawbacks to personal loans
While there are some advantages to personal loans, it’s also important to be aware of the potential drawbacks that you might encounter with a personal loan.
Increases your debt
Obviously, when you take out a personal loan, you’re adding to your total debt burden. This can put a strain on your finances if your monthly budget is already stretched pretty thin. That’s why you should carefully evaluate your financial situation and reasons for taking out a personal loan.
Penalties and fees
Not only are you paying interest on personal loans, but you may also be charged application fees or origination fees. An origination fee is usually between 1% to 5% of the loan, and most lenders deduct the fee from the loan amount. So even if the origination fee is only 1% and you borrow $10,000, you would only take home $9,000.
Some lenders may also charge prepayment penalties as well if you pay off the loan early. These days, most financial institutions have eliminated prepayment penalties, but it’s never a bad idea to make sure that’s the case before you agree to the loan.
Pro Tip
Some lenders advertise “no-fee” loans. Just be sure you’re not paying a higher interest rate in exchange for the lack of fees. In any case, read the loan terms carefully so you’re aware of the total cost of the loan.
Can negatively impact credit report
Just as a personal loan can help your credit score, it can also have a negative impact as well. For one thing, as part of the application process, lenders will make a hard credit inquiry. This is when they look at your full credit history and it will cause your score to drop temporarily for up to two years.
Plus, you’re taking on additional debt, which will increase your debt-to-income (DTI) ratio. DTI is something else lenders look at when deciding whether to approve loans or credit card applications.
Higher interest rate than a secured loan
An unsecured personal loan (which is most common) is a loan that is not secured by any collateral. That means if you default on the loan, the lender has fewer resources to get their money back.
Because of the additional risk, you’ll pay a higher interest rate than you would with a secured loan like a home equity loan.
Should you get a personal loan?
It’s important to both evaluate your financial situation and ask yourself a few questions before you decide if a personal loan is the right choice for you.
Can you afford it?
Before you take on more debt, it’s important to go over your budget to see if you have enough money to cover an extra monthly payment for the next few years. If you’re struggling as it is, a personal loan might not be the right choice.
On the other hand, if you have a surplus of cash every month, you might be able to fit a personal loan into your new budget.
Do you have a good credit score?
Your credit score is one of the biggest factors in determining the interest rates and loan terms you can qualify for. If you have a poor credit history, you may not be able to get a personal loan with an interest rate that’s better than a credit card. Or, you may need to get apply for a secured personal loan, which puts your assets at risk.
Do you have a low debt-to-income ratio?
Most lenders will also look at the amount of your monthly debt payments in relation to your gross monthly income. If your DTI ratio is too high (more than 40%, give or take depending on the lender), you may not qualify for the personal loan, or the interest rate will be prohibitively high.
You can calculate your DTI by dividing your total minimum monthly debt payments by your gross income. For example, if you bring home gross pay of $3,000 a month and your debt payments come to $1,000 a month, your DTI is 33%, which isn’t bad.
Are you interested in consolidating debt?
If you have a good credit score and want to use a loan to pay off your credit card balances, a personal loan might be an excellent choice. You can simplify your budget by having fewer monthly payments and benefiting from lower interest rates at the same time. Just be careful not to run up your credit card debt again!
Do you want to make home improvements?
Many people use personal loans to finance large home-improvement projects. If you have the credit score to get good rates, using the money to add value to your home can be a great investment.
A personal loan for home renovations is a good idea if, for example, you don’t have enough equity in your house to qualify for a home equity loan or HELOC.
Personal loans offer versatility, allowing borrowers to use the funds for a variety of purposes. — Brian Samelko, Head of Personal Lending at PNC BankClick to Tweet
Alternatives to personal loans
As mentioned previously, a personal loan may not be the best answer for everyone. It’s a good idea to consider other options to finance your project, pay off your debt, or make a big purchase.
Secured loans
As mentioned earlier, secured loans are secured by an asset, such as a car or — in the case of home equity loans or home equity lines of credit (HELOCs) — your house. If you have equity built up in your home, these types of lending can come with a lower interest rate and give you more time to pay the loan back
You may also want to consider selling some of the future equity in your own home with a home equity agreement. This is not a loan, per se, so you have no monthly payments to budget for, and you can get a lump sum of cash without the strict credit requirements of other options.
Credit cards with 0% introductory rates
Credit card issuers are incredibly competitive and want your business. For this reason, many of them offer cards with 0% introductory rates, which can run anywhere from six to 24 months. If you qualify — and, crucially, pay off the debt within the introductory period — you just got yourself a no-interest loan.
If you’re thinking about a personal loan to pay off credit card debts, you could apply for a 0% credit card and make use of the balance transfer option instead. You’ll typically have to pay a balance transfer fee of 3% to 5% of the balance, but there’s a good chance that will still be less than paying interest on a personal loan.
Savings
Think carefully about why you want to borrow money. Do you really need the funds right away or can it wait? For example, if you want to plan an amazing trip or are getting married in a couple of years, you might try to save money for those goals rather than getting into debt.
Instead of taking out a personal loan, estimate what you might have budgeted for a monthly payment to pay it back. Then make that monthly payment to your high-yield savings account instead. If you pay yourself rather than a bank or credit union, you don’t have to get into debt or pay interest.
Key Takeaways
- A personal loan isn’t the right choice for everyone. Be sure to evaluate your specific purpose for the personal loan funds and the pros and cons of personal loans in general.
- Though personal loans tend to have better interest rates than credit cards, they also have higher rates than other loans like secured loans.
- A personal loan is usually an unsecured loan, meaning you don’t need collateral to qualify for it. That said, you’ll need a good credit history to make up for the lack of collateral.
- A home equity loan, home equity agreement, or 0% credit cards are some alternatives to personal loans.
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