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Understanding the advantages and disadvantages of personal loans is important when shopping for a lender and deciding whether to apply for financing. While personal loans can be beneficial in many situations, they can also come with high interest rates and significant repercussions on your credit score. However, the benefits of these loans may outweigh the risks – especially if you qualify for a competitive rate and need quick access to cash.
Regardless of your circumstances, here are some tips to help you deal with this borrowing decision.
What is the benefit of getting a personal loan?
Personal loans can be an excellent option if you want to consolidate high-interest debt or need cash for a home improvement project or other major expenses and can afford to pay off. Not only are most personal loans unsecured – meaning the lender doesn’t need collateral – many come with competitive interest rates and no fees.
With that said, there are some downsides to getting a personal loan, so it’s important to assess your needs as well as the pros and cons of a personal loan before borrowing.
Advantages of personal loans
Personal loans can be very beneficial under the right circumstances. Personal loans may be beneficial because they can:
1. Helping borrowers build credit
Getting a personal loan requires making regular monthly payments towards the outstanding balance. Lenders typically report your payment history to the three major credit bureaus – Equifax, Experian, and TransUnion.
If you consistently make on-time payments, this can help increase your credit score; Payment history represents 35% of your FICO credit score. It also means that you can damage your score if you make late payments or default, making it difficult to access credit in the future.
2. Let borrowers pay for purchases over time
Lenders disburse personal loans as a lump sum that you can use to make a purchase or pay off other debts. This allows borrowers to make large purchases and then pay for them over time, without saving money up front. While this can be a good strategy for necessary purchases, it can become dangerous if you rely on loans to go on vacation or cover other discretionary spending.
3. Facilitate debt collection
Debt consolidation loans allow borrowers to simplify their finances by paying off individual loans and credit card balances with a single personal loan. Not only does this reduce the number of payments you have to remember each month, but it may also result in a lower total interest rate if your credit score has improved since taking out your other loans.
Some lenders specialize in debt consolidation and will pay off your other debts directly instead of cashing in your account.
Related: Pros and cons of debt consolidation
4. Used for almost anything
Personal loans are a popular financing option because they are so versatile, and you can use them to cover everything from auto repair costs to home improvements and event-related expenses, such as weddings.
Acceptable uses of a loan vary by lender, but most institutions allow borrowers to use the money for any personal, family, or household purposes. Personal loans may not be used for further illegal activity. Some lenders also restrict whether personal loan money can be used to purchase real estate, pay for post-secondary education, or start a new business.
Related: 6 good reasons to get a personal loan
5. Offer competitive prices
Personal loan annual percentage rates (APRs) typically range from just 3% to 36%, with the most competitive rates reserved for highly qualified applicants. While the higher range of rates can go up, many applicants qualify for a lower APR than is available with a standard credit card. However, these rates are still higher than secured loans such as home purchase loans.
If you’re considering a personal loan, take time to pre-qualify with top lenders to see what kind of rate you’re likely to get.
Related: What is a good interest rate for a personal loan?
6. Provide flexible limits for borrowing
Borrowing limits vary by lender, but personal loans are usually available between $1,000 and $100,000. For this reason, personal loans can be designed to meet the borrowing needs of most consumers. Just keep in mind that getting a $100,000 personal loan will likely be more difficult than qualifying for a smaller, less risky amount. Alternatively, if you plan to finance a small purchase, a credit card or point-of-sale financing may be the best option.
7. Eliminate the need for guarantees
Most personal loans do not require the borrower to pledge any collateral. This means that you don’t have to risk losing a valuable asset – such as your home or car – if you default on the loan. However, keep in mind that unsecured loans usually come with higher interest rates and may be more difficult to qualify for as they pose more risks to lenders.
8. Provide quick access to cash
Personal loan application processing and financing speeds vary, but many lenders announce same-day or next-day financing. So, if you are facing unexpected auto repair costs or emergency travel needs, it may be possible to get a personal loan.
However, if you need funds quickly, carefully research the entire loan application process. The actual time it takes to apply, get approved, and receive loan funds can be longer depending on when you apply, the size of the loan, and how quickly your bank allows you to access the funds after disbursing them.
Disadvantages of personal loans
Loans can be a great way to make ends meet, but there are also some risks and drawbacks associated with getting a personal loan. Before you borrow, keep in mind that personal loans may:
1. Accumulating high interest fees
While more creditworthy personal loan applicants can qualify for lower APRs, others may face higher rates of up to 36%. Depending on your loan offer, this rate may be significantly higher than rates available through other types of financing, such as home equity loans, home equity lines of credit (HELOC), student loans, and 0% APR credit cards. Consider all personal loan alternatives before signing on the dotted line.
2. Come with fees and fines
In addition to interest rates, many lenders charge application fees and set-up fees to cover the cost of processing. Likewise, the borrower may face penalties for late payment or not having enough funds to pay. Some institutions also charge penalties for prepayment, although the most competitive lenders do not. When shopping for a personal loan, keep an eye out for additional fees and penalties that may increase the cost of borrowing over the life of the loan.
3. Lead to credit damage
Just as lenders report a positive payment history to credit bureaus, they also report late payments and non-payments. For this reason, borrowers who fail to make payments on time — or who default on a loan completely — are more likely to find themselves with a lower credit score. Furthermore, getting a personal loan increases the borrower’s credit, which is 30% of your FICO credit score.
4. Request guarantees
If you do not have a high enough credit score to qualify for a secured loan, you may have to pledge assets as collateral. This is mostly the case with applicants who have a FICO credit score of less than about 585. In the case of a secured personal loan, the lender can keep the collateral if you default. Joint guarantees include assets such as the borrower’s home, car, boat, or certificate of deposit (CD).
5. It results in unnecessary debts
Depending on your reason for getting a personal loan, this type of financing can lead to unnecessary debt. Before committing to a loan – big or small – assess why you are borrowing money and whether a personal loan is the best solution.
Is a Personal Loan Right for You?
A personal loan may be right for you if:
- You have a high credit score and it will help you qualify for a low interest rate
- There is room in your budget for a new monthly payment
- You want to consolidate multiple high-interest debts
- The debt-to-income ratio (DTI) is 36% or less
- You will not be eligible for a 0% APR credit card
- You are dealing with a project that will add value to your home