Borrowing money isn’t necessarily a bad thing. In fact, it can be very helpful in some situations. You can build your credit, purchase something you need, and arrange payments you can afford. However, deciding when to take out a personal loan is a decision that should be weighed carefully. According to Katie Ross, the Education and Development Manager from the American Consumer Credit Counseling Organization,
“When considering taking out a personal loan, it’s important to consider if the reason is responsible or if you’re just adding more debt to the pile,” Ross says. “Many look to personal loans as a quick fix for financial problems or for pursuing goals. This is a dangerous attitude to have, because personal loans can affect credit standing and have complex terms.”
With this in mind, let’s look at some of the best and worst ways to use a personal loan.
Best ways to use a personal loan
Consolidating debt is a move to pay off your old debts by transferring them into one new loan. Doing so also allows you to reduce the amount of stress you may be experiencing from managing multiple accounts, can give you more control over your situation, and can help you see the progress you are making toward being debt-free.
“If your debts have gotten out of hand and you’re struggling to keep track of payments, a personal loan can be used to pay off creditors thus consolidating all your payments into one monthly bill,” Ross says.
Loans often have a better interest rate than some credit cards or other debt, so this is an acceptable method to manage debts.
“The important thing here is that the personal loan is not new debt,” Ross says. “You’ve simply transferred multiple debts into one location.”
Help with home purchase
Another good way to use a personal loan is to help with the purchase of a home. The loan may be taken out to be used as a down payment or to help cover other expenses, such as closing costs. This is usually a good investment, because you build equity as you make your mortgage payments. Once it is fully paid, it becomes a valuable asset. Keep in mind that a personal loan will affect your debt-to-income ratio, which can affect your ability to get a mortgage.
Maintaining a home
Speaking of your home being a good investment, it’s also important to protect it by keeping it in good shape. This includes preventative maintenance and repairing unexpected problems that come up. For example, if your roof is leaking and it is time for a new one but you can’t afford to pay for it out of pocket, taking out a personal loan to fund it would be a good idea. You are preventing further damage to your home and increasing your home’s value.
“If you own a home and need to make repairs, a personal loan can help get the work done quickly if you don’t have time to save up for it,” Ross says. “This is an appropriate use of a personal loan, because the cost of the loan is at least partially offset by increasing the equity in your home.”
Buy or repair a car
Like a home, a car is going to be a big investment for you. Being able to go wherever you need to go, when you need to go, makes a lot of difference with your job, business and life.
So if you need a new car to get to work or school, a personal loan can be used to help purchase it. You also may opt for an auto loan, which is secured by the vehicle, or a combination of both. However, there’s a fine line between necessity and luxury. Look for a good deal on the car and be sure the purchase is reasonable for your income level.
Repairing a car is also a good use for a personal loan because, in many cases, you are investing in something that is going to help you get to work and generate income.
Help start up your business
Starting your own business can be pretty expensive with the need for permits, office space, equipment, inventory, a website and much more. Many budding entrepreneurs are on a tight budget and a personal loan can help to fund a startup. While new businesses can be risky endeavours, Ross says that you are “using the loan to establish a new means for making money, which will enable you to pay the loan back in a reasonable amount of time.”
Your health is a top priority and it’s important to invest in it to ensure you stay healthy. Health insurance is a necessity, but it can only do so much. Many medical expenses go beyond what insurance covers. When this happens, you’re better off getting a personal loan to pay those medical bills up front.
What all these personal loans have in common is that you are using the money to invest in things that benefit you in the long term: your budgeting goals, your health, your car, your home and/or your business.
On the flip side, there are uses of personal loans that have little to no long-term benefits.
Worst ways to use a personal loan
Once you find out you can get a personal loan, you may start imagining the beaches in Hawaii or jungles of Costa Rica, but you’ll want to pump the brakes on those daydreams.
“Taking out a loan to go on a vacation is a surefire way to create unnecessary personal debt,” Ross says.
She says many consumers take out loans to go on “once-in-a-lifetime” trips. The problem is that it ends up taking years to pay it off. Think about if the two-week vacation is worth years of monthly payments.
The best advice is to take a vacation when you’ve got extra cash on your hands. That’s when you know you’ve earned a break.
Another common pitfall is taking out a personal loan to pay for a lavish wedding. According to Market Watch, one-third of couples go into debt for their wedding day. While getting married should be a memorable experience, you don’t want to start your marriage off on the wrong foot. Don’t be pressured into expectations from the people around you, because they’re not the ones who’ll be paying off the loan once you’re back from your honeymoon.
Ross advised against upgrading your wedding with a personal loan because “wedding costs can balloon quickly without much thought being given to the fact that once the day is over, this money is gone.“
If you really want that dreamy wedding of yours, then save up for it. Your future self will thank you for not starting off your married life worrying about long repayments and high interest rates.
Don’t let lenders take advantage of your eagerness to be the modern-day Santa Claus. While you want your kids and loved ones to be happy during the holidays, personal loans are not the best way to pay for gifts. Once the holidays are over, the feelings fade and toys are forgotten, but the debt remains. You should consider how limited you’ll be the rest of the year in what you can give as gifts because of your holiday debt.
Debt should be a planned financial decision with a reliable outcome. It’s therefore wise to avoid getting personal loans for things in which outcomes are out of your control. Nothing is more unpredictable than gambling.
Stock market ventures
The same goes for the stock market, which is a kind of gamble in itself. Unlike other business investments in which you have more control over your profits, the stock market is very volatile and people can lose as much as they can profit in a matter of minutes. Some day you may have the funds to invest in the stock exchange, but don’t take out a personal loan to do it.
Paying bills or buying everyday items
Lastly, you may have bills piling up, need some new clothes or need groceries, but a personal loan isn’t a good solution for these recurring costs. “Instead, consumers should look into their complete financial picture and figure out what they need to change in terms of their lifestyle and budget in order to live within their means,” Ross says.
How to find the right personal loan for you
Check your credit score
The terms you get on a personal loan vary depending on your credit. The better your credit score, the more you’ll be able to borrow and the less you’ll have to pay for it. Before shopping around to find the best loan, check your credit score to find out where you stand. You will find that different lenders cater to different credit levels.
Compare interest rates
There are two kinds of interest rates for personal loans. Variable rates go up or down depending on the indexes, which can work for or against you. Fixed rates are easier to plan for because they never change. The variable or fixed rate you are offered will depend on your credit.
Calculate fees and penalties
The kind of fees and charges that come with your personal loan ultimately affect the overall cost of that loan. Origination fees and loan approval fees range from 1% to 6% of the loan value, which depends on your credit rating and the lender you choose. Some lenders also will impose prepayment fees for those who end up paying their loan before the end of the term. Make sure you factor in these and any other fees when assessing the loan’s overall cost.
Evaluate lender legitimacy
Make sure you’re working with a lender you can trust. Find out by doing your homework. Check reviews from third-party sources.
While you’re at it, take the time to compare lenders so you can find the best personal loans available. Don’t settle for one you think is favorable, because you might end up losing out on a better deal.
Compare personal loan lenders
Ready to browse personal loan options? Check out some of these lenders and find yourself the best deal available.
Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.