If you find yourself in a tough spot and in need of financial help, personal loans can be a tempting option. But just because you could get a personal loan doesn’t necessarily mean that you should.
To help you decide for yourself, we’ve put together a list of pros and cons, as well as some alternative financing options for you to consider.
Pros and Cons of Personal Loans
There are several possible advantages and drawbacks associated with personal loans depending on what you plan to use one for. Understanding their potential risks and rewards is critical to making an informed decision.
Advantages of personal loans
- Versatility: Once you receive the funds from a personal loan, you can use them for almost anything you need, making them one of the most versatile financing options available.
- Could lower your interest rate: If you have high-interest credit card debt, taking out a personal loan to pay it off could give you a lower interest rate.
- Quick cash: Applying for a personal loan is a more streamlined process than other types of loans, like a mortgage or a home equity loan. You could potentially get access to the funds you need significantly faster.
- Could simplify payments: If you plan to use a personal loan for debt consolidation, you can reduce the number of monthly payments you owe and simplify your financial bookkeeping each month.
- Could improve your credit score: If you use a personal loan responsibly and are diligent about making on-time payments, it could improve your credit score overall.
- No collateral: If you apply for an unsecured personal loan, you won’t need to make a down payment to secure the loan or put up personal property as collateral.
- No closing costs: Other types of loans come with closing costs, which can be significant depending on how much you borrow. Personal loans don’t have those expenses, reducing the upfront amount you need.
Disadvantages of personal loans
- Higher interest rates than some alternatives: Generally, personal loans will come with higher interest rates than mortgages, auto loans or other types of secured loans.
- Limited maximums: Compared to a mortgage or a home equity loan, personal loans have significantly lower maximums, usually capping out in the ballpark of $45,000. Depending on what you need the funds for, that might not be enough to cover all your expenses.
- You’re taking on more debt: If you take out a personal loan, you’re taking on debt. If you don’t handle your finances responsibly, this can put you in a worse financial position than before you took out the loan.
- Your credit matters: Your credit score will be evaluated with your application. A lower credit score will result in higher interest rates on the loan, and if your credit score is too low, the loan will be denied altogether.
- Higher minimum payments than credit cards: There’s no deadline for paying off a credit card balance, which translates to lower monthly minimum payments. Personal loans come with loan terms attached, which means higher minimum payments compared to credit cards. This could put you under financial strain.
When Is a Personal Loan a Good Idea?
From emergency expenses to home improvement projects, there are a lot of different ways to use the funds from a personal loan. Regardless of what you intend to use the money for, here are some common situations where a personal loan could make sense.
You have excellent credit
If you have excellent credit, you could qualify for better interest rates on personal loans. Getting a better interest rate will make the loan more affordable in the long run. This could make a personal loan an even more appealing option.
You need funds fast
In emergency situations, sometimes you need access to capital quickly. Personal loans can be issued fast, sometimes as soon as one business day.
There aren’t that many loan options available that can lead to a lump sum transfer that quickly.
You want to consolidate payments
If you’re making multiple monthly payments – for example, if you have credit card debt on multiple cards – you can use a personal loan to consolidate your debt. This can significantly lower the stress of keeping up with your payments by reducing the number of accounts you need to keep track of. It will also ensure your monthly payment is fixed, allowing you to budget for the future confidently.
You could improve the value of your home
Home improvement is one of the most common uses for a personal loan. Upgrading a kitchen or a bathroom can be expensive, but if done well, it can add a lot of value to a home.
If you have the opportunity to make home improvements that will return value, and you have the means to repay the loan, a personal loan could be a prudent way to afford the upgrades.
Questions To Answer When Considering a Personal Loan
To help aid your decision-making process, we’ve put together a list of questions to ask yourself when deciding whether or not a personal loan is right for you.
Remember, you can use a personal loan for almost anything. However, we recommend making sure the expense is essential or has the potential to help out your long-term financial situation. Consolidating your debt is more likely to meet this standard than taking a vacation.
Taking out a personal loan is taking on debt. This will affect your debt-to-income (DTI) ratio, and depending on how much debt you already have, this can be especially risky. If there’s a way to pay for what you need without taking on debt to do it, you should strongly consider that path.
Personal loans can range from around $2,000 to $45,0000. Make sure that this will be the right amount for covering your expenses.
Personal loans can be issued fast, but if you aren’t in a rush, other types of loans (like a home equity loan) could offer better interest rates and higher loan values.
If you can’t repay the loan, you could do a lot of damage to your credit score and you may find yourself worse off financially. Make absolutely sure you can repay the loan before taking one out.
Take the time to look into alternative financing options. We cover some of the more popular ones in the next section.
Alternatives to Personal Loans
A personal loan isn’t your only financing option. Here are some alternatives worth looking into:
- Home equity loan: Home equity loans are technically second mortgages that allow you to borrow against the equity you’ve built in your home. They can provide higher loan amounts for those able to wait out a longer approval process.
- Cash-out refinance: A cash-out refinance replaces your existing mortgage with a new one, which will value your home at a higher price point. Your first mortgage gets paid off by the new mortgage, and you will receive the increase in your home’s value in cash.
- Credit card: Depending on how much you need, you have the option to charge the expenses to a credit card. Some credit cards come with perks like cash back or travel points that make this an appealing option.
- 401(k) loan: You have the option to borrow against your 401(k) if you work for a company that provides one. When deciding between these options, you’ll want to consider the differences between 401(k) loans and personal loans.
Final Thoughts On Deciding if a Personal Loan is Right For You
Personal loans can be a valuable tool if they’re used responsibly. However, if your financial circumstances or habits make it difficult to repay the loan, you could face serious consequences and even end up in a weaker financial position.
Make sure to do your due diligence, and talk to your lender so you thoroughly understand what you’re committing to before proceeding.
The Short Version
- Pros include a lump sum payment that can be used in a lot of ways, fast funding and potentially no collateral
- Cons include higher interest rates than alternative options, taking on more debt and the potential to damage your credit and financial situation
- A personal loan might be a good idea if you have an excellent credit score, if you need funds fast or if you are looking to consolidate your debt