When Does it Make Sense to Get a Personal Loan?

Whether you need money to pay for an emergency, want to consolidate debts, are planning a wedding, or financing your business, a personal loan can offer you quick and easy access to cash. The application process is often straightforward, and while lenders may ask why you want to borrow money, you’re often free to spend it however you’d like.

As with other types of debt, personal loans can be valuable financial tools. However, when used improperly, they can also pose a risk to your finances.

There are Two Types of Personal Loans

Personal loans can either be unsecured or secured debt.

When you take out a secured personal loan, you’ll need to offer the creditor collateral. You could put up your car, home, savings account, or something else of value, and if you don’t repay the loan, the creditor can take the collateral as repayment.

Unsecured personal loans don’t require collateral, although the creditor could sue you and take money from your paycheck or bank account if you aren’t making payments.

Both unsecured and secured personal loans are installment loans, meaning you receive the entire amount up front and make monthly payments. Generally, if you’re approved for the loan, you’ll be able to choose between different repayment periods, such as 24, 36, or 60 months. The interest rate may range from below 5 percent to over 30 percent, and there’s often a minimum and maximum amount you can borrow.

You may also be able to choose between a fixed and variable-rate loan. A loan with a fixed interest will have the same interest rate throughout the life of the loan — meaning your monthly payment will never change. Variable-rate loans often start with a lower interest rate than a fixed-rate loan. However, variable interest rates can increase in the future, which can lead to higher monthly payments and a greater cost to you over the lifetime of the loan.

If you can repay a loan quickly, a variable rate may save you money, but if you want a definitive budget for the future, a fixed-rate is the way to go. The longer it takes you to pay off the loan, the greater the chances are that the interest rate will increase.

How Does Your Credit Impact the Decision?

Your credit history and score, employment status, income, and other debts may determine the amount you can borrow and your interest rate. Some lenders will also consider your education and career. While these factors are often more important for unsecured loans, lenders of secured loans may take them into account as well. Those with excellent credit get the best terms on secured and unsecured loans.

Unsecured personal loans tend to have higher interest rates than secured loans and lower interest rates than credit cards, but there’s more to consider than the interest rate. It may make sense to pay a bit more in interest on an unsecured loan than to risk losing your home, or other valuables because you’re unable to make payments in the future.

If you have poor or no credit, you may not qualify for an unsecured loan, and if you do the annual percentage rate (APR) could be as high as 30 or 36 percent. It likely doesn’t make sense to borrow money at 36 percent APR to pay off credit card debt or consolidate bills, but it still could be a good option compared to a payday loan, pawn shop, or other forms of secured debt. For example, according to the Federal Trade Commission, car title loans, which use your vehicle as collateral, may have an APR over 300 percent.

Here’s a look at how personal loans compare to other repayment options, in terms of total interest paid. This chart assumes a $10,000 debt, no origination fee, and a 36-month repayment.

Type Estimated APR Total Interest Paid (36 months)
Personal Loan (good credit) 10% $1,616.19
Credit Card (good credit) 15% $2,479.52
Personal Loan (fair credit) 20% $3,378.89
Payday Loan 200% $50,234.29

As you can see, good credit will enable you to earn a lower interest rate, which in some circumstances can save you thousands of dollars.

Why do People Take Out Personal Loans?

Unlike an auto loan, student loan, or mortgage, personal loans allow you to borrow money and use it however you want. Broadly speaking, there are four reasons you might want to apply for a personal loan: to consolidate debts, to save money, to pay for a want, or to pay for a need.

To Save Money By Paying Off a Higher-Interest Debt. You may be able to take out a personal loan and use the money to pay off a higher-interest debt, such as credit card debt. This could save you money in interest payments and you’ll know when the debt will be paid off, which can be hard to predict with revolving credit accounts.

To Consolidate Debts. Similar to the point above, but interest rates aside, you could use a personal loan to pay off several other loans. Consolidating your debts can make it easier to manage your bills, lead to lower monthly payments, and might save you money if you’re consolidating high-interest debts. A personal loan isn’t the only way to consolidate debts, and you may want to compare this option to using a balance-transfer credit card with a 0-percent-interest offer. One option may be better than the other depending on the type and amount of debt you have, as well as the fees you’ll pay on a loan or the card.

To Pay for a Need. A personal loan may be a good option if you need money for an investment or emergency. Perhaps you want to pay for professional development coursework or a home improvement project, or need the money for medical expenses.

To Pay for a Want. Defining wants and needs can be difficult, but if you’re honest with yourself, you’ll likely be able to recognize the difference. It generally makes more financial sense to save up for a “want” beforehand than to borrow money and pay off the loan with interest.

If you’re thinking about using a personal loan to pay off debt, keep in mind that there are other options. And remember that a personal loan won’t address underlying financial behavior. If bad financial habits are what landed you in credit card debt in the first place, consider a debt management program to help get your spending under control and keep your finances organized.

Using a loan to pay for needs may be a good option and could be less costly than alternative forms of payment, such as a credit card or medical payment plan. Unless you have a large emergency fund, you may want to lean slightly towards unsecured loans rather than put your personal property at risk by using it as collateral.

When you have a good reason to take out a personal loan, you can shop around to find the best terms possible.

Where Can You Find a Personal Loan?

You can get secured and unsecured personal loans from banks, credit unions, and online lenders. The loan’s terms, credit requirements, and the amount you can borrow varies from one lender to the next.

Depending on your circumstances and needs, you may want to look for a loan from an online lender that specializes in unsecured personal loans for people with poor credit. Alternatively, a local credit union might offer you the best rates on a secured personal loan, using a savings account or Certificate of Deposit (CD) as collateral.

You can often get an get an approximation of the interest rate and repayment periods each lender will offer you before agreeing to borrow the money. But first, check to see if doing so requires a hard inquiry – which could temporarily hurt your credit.

What to Watch out for When Shopping for a Personal Loan

In addition to the amount you can borrow and the repayment terms, you may want to compare potential fees.

Origination Fees. Some lenders charge borrowers an origination fee when they issue the loan. Either a flat fee or a percentage of the amount you borrow, the fee might be taken out of the money you receive.

Prepayment Fees. Depending on your loan’s terms, you may need to pay a penalty if you repay the loan early.

Lenders that don’t charge fees don’t necessarily have the best or cheapest option. Consider the monthly payments and how much you’ll pay in interest over the lifetime of the loan. Comparing APRs rather than interest rates can help, because the APR incorporates fees and other expenses.

Bottom Line

You may be able to use a personal loan to weather a financial setback, strategically pay off debt, or make a large investment; however, you may want to reconsider borrowing money to pay for a want. When you do determine that taking out a personal loan makes sense, compare the differences between secured and unsecured loans based on your needs and credit. Then, shop around for a loan to find the best terms before borrowing the money.

Louis DeNicola is a personal finance writer with a passion for sharing advice on credit and how to save money. In addition to being a contributing writer at Clearpoint, you can find his work on Credit Karma, MSN Money, Cheapism, Business Insider, and Daily Finance.

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