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The Pros And Cons Of a Personal Loan

Wondering whether a personal loan it's the right thing to do? Here are the main pros& cons and some alternatives you should know before apply

Table of Content

The decision whether to apply for a personal loan will be determined by your requirements and preferences. A personal loan may be a good option if you need money but will need more than a year to repay it. It will enable you to repay a set amount each month, allowing you to budget accordingly.

However, if you only need money for a short period of time and will be able to repay it quickly, you may be better suited to another type of finance, such as a credit card with a 0% introductory rate.

What Is a Personal loan?

A personal loan is a fixed-rate installment loan, normally ranging from $500 to $100,000 and they are usually unsecured, so there is no collateral that covers them.

The loan always has a fixed monthly payment amount and an end date when the loan would be fully paid off.  Interest rates will differ from lender to lender and your creditworthiness.

Borrowers commonly use a personal loan to consolidate credit card debt or pay for a big, one-time expense like a surgery, wedding or a funeral.

What is an Unsecured?

As the name suggests, an unsecured personal loan does not require you to provide any security. This means that your loan is based on your credit score and ability to repay.

Since the lender does not have any asset tied to the loan, there is a higher risk, so this is often reflected in the rates. You can expect a higher rate with an unsecured personal loan compared to a secured loan or mortgage.

There are a number of factors that influence personal loan APRs. One of the factors with the most weight is credit score. If you have a lower credit score, you represent a greater risk to the lender and this is reflected in the rate. In this chart compiled with LendingTree customer data, you can see that those with a 720+ credit score pay an average of 7.63%. At the other end of the scale, those with a poor credit rating of less than 560, the rate shoots up to an eye watering 113%.

Personal Loan Average APR by Credit Score

How Do They Work?

If we were in the 80’s and you were applying for a loan, lenders would first want to know your credit score and you must show them your tax returns and employment details.  Only then would they decide whether to give you a personal loan or not and if so, how much interest to charge you.

But now, in our technology-driven time, a whole new type of lenders has emerged.  These lenders utilize non-traditional factors such as your SAT scores and social media accounts to make decisions on your loan application.  Comparatively, it’s a lot easier to get a personal loan now than it was years ago when the only options were credit unions and traditional banks.

Personal loans come in many sizes and lengths.  You have loan terms that can go for a full year or more.  You have short loans such as payday loans that become due in just a couple of weeks after they lend you the money.

The usual practice is, if you are able to repay a payday loan within the small window of time they give, you won’t have to pay interest at all.  However, the lender will still require you to pay the origination fee for the loan.

Some other forms of personal loans start accumulating interest right at the start such as installment loans.  The amount of interest you have to pay will depend on how much your loan is and the interest rate you agreed to pay.  Some lenders adjust the interest rate downward if you get a loan with a longer term.

Let’s go through the pros and cons of a personal loan.

Personal Loans Advantages

Whatever you need it for, there are several benefits to getting a personal loan rather than other types of loans. Here's how a personal loan can help you achieve your financial objectives.

We’ve mentioned before that personal loans are unsecured loans.  This means that the lenders will not require a mortgage of assets or a guarantee for them.  This is where personal loans have an edge over other types of loans because even if you don’t have any fixed assets to offer, you can still get a personal loan to get you out of a bind, or even for other purposes such as investment.

In effect, you do not have to worry about losing your home or any of your other assets in case you encounter a financial setback and fail to make on-time payments.

Personal loans offer a flexible form of finance, as they can be used for practically any purpose. In this chart compiled from LendingTree consumer data, you can see that debt consolidation is the most common reason for taking out a personal loan. The least common reason is for home improvement. This is likely due to more advantageous products that can be used for home improvements such as home equity lines of credit.

percent of Personal Loans by reason

These loans are available in almost all banks or financial institutions.  They need minimal paperwork and the time they need to verify the documents make the process of application quick, easy and simple.

The whole loaning process – from application to documentation and then release – takes less time compared to other kinds of loans.

So, when the need for funds is quite urgent, a personal loan is probably the best option

Lenders will not obligate their borrowers to specify the purpose or reason for applying for a personal loan.

Unlike housing loans where they restrict the use of the funds only for construction or purchase of a house, or an auto loan that you can only use for purchasing a vehicle, personal loans are multi-purpose.

With a personal loan, you’ll pay a specific amount of interest for a specified number of years.

Consider it this way:  shorter terms means lower interest over the years but higher monthly payments.  So, while it is an advantage, it could also be a disadvantage depending on where you sit.

Here’s how it goes: by consolidating multiple credit cards with a personal loan you will only have to keep track on one bill due instead of many. It would dramatically simplify a lot of things.

You can then focus your time, attention and resources on making that single payment, ticking off the months until you completely wipe out your debts.

Personal Loans Disadvantages

While personal loans are excellent in many situations, they do have a few drawbacks. Here are some things you should be aware of:

Since unsecured personal loans are riskier than those secured by property, lenders mitigate the risk by charging higher interest rates.  Take note that your rate will depend greatly on your credit score and the principal of your loan.  The secret is this:  some lenders may hide a significant portion of the interest in upfront fees such as loan origination and processing fees.

It keeps you in debt (and it’s getting bigger). Many banks and financial institutions will not allow partial repayment of a loan. Needless to say, this will result in your debt getting bigger and bigger due to the accrued interest.

So, if you take out a personal loan for $10,000 and want to repay $1,000, you won’t be able to.  The lender will not allow such partial payment unlike in the case of housing and other types of loans.  With other loans, you can reduce the amount of your loan through the repayment feature which also lowers overall interest.

Yes, you can choose your repayment period but first a warning: you can’t change it once it’s chosen.  Most lenders do not want to go through the hassle of modifying your terms.  This means that you can not prepay the loan or make part-payment.

Basically, you have to pay the required amount for the entire duration.  Plus, if you fail to pay the EMIs on time, you may already be courting legal action which could lead to more complications.

Lenders obviously need to follow strict guidelines with respect to eligibility criteria for personal loans.  Most banks and NBFCs will insist that borrowers meet a certain income level before even considering applying for a loan.

Aside from the income, they will scrutinize the credit score of an applicant and you’d be right to think that they can reject a loan due to a poor or average credit score.

 

 

When You Should Consider a Personal Loan?

Before you take out a personal loan, you should think about whether there are other, less expensive ways to borrow. Some valid reasons for obtaining a personal loan include:

  • You do not have and will not be able to obtain a low-interest credit card
  • You need quick money
  • A personal loan is your most affordable borrowing option
  • You have no collateral to offer
  • You're 100% sure you can pay it back

If you need to borrow for a relatively short and well-defined period of time, you may want to consider a personal loan. Personal loans are typically available for terms ranging from 12 to 60 months. So, if you have a lump sum of money due in a year but not enough cash flow in the meantime, a one-year personal loan could be a way to bridge the gap.

When You Shouldn't Consider a Personal Loan?

While personal loans can be a lifeline in times of dire need, there are some situations in which you should avoid borrowing money. Consider not taking out a personal loan if:

  • There are better alternatives – A home equity loan or line of credit may be a better option for home improvements and repairs. An auto loan can help you save money on a car or other vehicle.
  • You're not sure if and when you can pay it back – Borrowing money in the short term is one thing, but keep in mind that you will still have to pay it back. If you can't afford the monthly payments on your new personal loan, think about canceling it.
  • You don't really require it – If you're considering taking out a personal loan to cover the cost of a vacation or something you don't need right away, consider deferring it until you have more cash on hand.

Before you take out a personal loan, consider all of your options. Borrowing money should not be done on the spur of the moment. Instead, assess your financial situation to determine whether a personal loan is the best option for you.

Personal Loan Alternatives

A personal loan is one method of raising funds for whatever venture you have in mind.

Personal loans are a one-of-a-kind product. Loans are sought for a variety of reasons, and these, along with your current circumstances and credit history, all influence the amount you can secure, as well as interest rates and payback time.

  • Credit Cards

Credit cards, as opposed to personal loans, provide you with a revolving line of credit. This allows you to use as much of your credit as you want as long as you stay within a credit limit that has been set previously. You can also pay as much as you want toward your debt as long as you pay at least the minimum every month.

However, getting approval for a credit card can take time and frequently have higher interest rates than personal loans, so you'll want to pay off any debt as soon as possible. Credit cards are best for those who have good or excellent credit, as this influences your interest rate, loan terms, and any special introductory offers you receive.

Based on a survey by CreditCards.com, the national average credit card rate in 2019 stood at 17.57%. Americans who held bad credit cards were charged the highest interest rate of 24.99%, while the credit card for low interest enjoyed lower rates at 14.61%.

Chart: Credit Card Rates in the U.S. 2019, by Card Type

A balance transfer card can be useful if you want to pay off your existing credit card debt. These cards typically offer a lower interest rate for a set period of time, giving you some wiggle room to pay off the balance without incurring high interest fees. If you don't want or are unable to pay off your card balance right away, a 0% introductory rate card will allow you to avoid interest charges.

It is also critical to consider the fees associated with specific cards. While the interest rate is important, you should also look into the annual fee. Examine how the annual fee affects the card's rewards.

  • Home Equity & HELOC

A home equity line of credit gives you access to a pool of money—the credit line, or borrowing limit—that you can draw from as needed by writing checks or using a dedicated card to make charges or cash withdrawals. You don't have to pay interest or make payments until you use your credit, and then, just like with a credit card, you can make payments of any amount (as long as you meet a monthly minimum) to pay down the balance as quickly or gradually as you can. The longer you wait to pay off the balance, the more interest you'll have to pay.

A home equity loan is a lump sum of money borrowed against your home's equity. Second mortgages are another term for home equity loans. A home equity loan, like your primary mortgage, is secured by your home, which means the lender can seize the property if you fail to repay the loan as agreed.

Home equity lines of credit are loans that allow the homeowner to borrow against the equity in their property. This can be an effective way to restructure finance, pay for home improvements or pay for a significant purchase.

As the following chart using FED Survey of Consumer Finances 2019 data, the average by family lines of credit fluctuates over time. In 2001, the average was at a low of $37,000 per family. This peaked in 2010 at $64,000.

Home-Equity Lines of Credit (HELOC)

Both can be used to fund large expenses such as home renovations, which can increase the value of your home over time. Both are offered by lenders such as traditional banks, credit unions, and online lenders. And they are both secured or guaranteed by the same asset — your home. That means that if you do not repay, the lender may foreclose on it.

If you decide to pursue either of these alternatives to personal loans, you'll need to gather information such as how much you owe on your mortgage and the value of your property, in addition to the standard documents required when applying for a loan or line of credit, such as personal identifying and income information.

  • 401(k) Loans

Borrowing against funds in an employer-sponsored retirement plan is possible with 401(k) loans. To qualify for a 401(k) loan, you do not need to submit an application or supporting documents, and you do not need to have a minimum credit score. As a result, they are ideal for borrowers who do not meet the loan requirements of a traditional lending institution.

The primary distinction is that personal loans are unsecured. That is, there is no collateral to secure the loan if you fail to repay it. There is nothing for a lender to repossess. A 401(k) is secured by the amount of money in your retirement account. And, in the case of the 401(k), the lender is you. You're taking a loan from yourself. Unfortunately, some 401(k) loan recipients later come to regret their decision. This could be related to what some refer to as “borrowing against your future.”

If you qualify for the lowest interest rates and can afford the monthly payment, you have a strong case for a personal loan. If your job situation isn't rock solid – if you're looking elsewhere or your position is in jeopardy for any reason – a personal loan is far less risky than a 401(k) loan. It doesn't help to save 15% on interest if you have to pay 40% in penalties for leaving your job. If you don't need to borrow more than a few thousand dollars, a personal loan makes sense.

Of course, each person's situation is unique, and the outcome will most likely be determined by the interest rate you receive, your ability to repay the loan on time, and your level of comfort with the employer (401(k) loans) or lender (personal loans).

The Bottom Line

To sum up, a personal loan is ideal when there is a short-term cash requirement but the borrower does not have any available collateral and needs the money fast.  However, before taking this loan, a borrower should remember that this loan carries a higher interest rate.  Financially, it can lead to more problems if he is not able to pay the loan.

FAQs

As the name suggests, an unsecured personal loan does not require you to provide any security. This means that your loan is based on your credit score and ability to repay.

Since the lender does not have any asset tied to the loan, there is a higher risk, so this is often reflected in the rates. You can expect a higher rate with an unsecured personal loan compared to a secured loan or mortgage.

Just like with a mortgage, home equity loan or even credit card, a personal loan attracts interest fees. This is a percentage of the loan amount which you need to pay on top of repaying the loan amount. So, if you have a personal loan of $1,000 with a rate of 5% and a term of one year, at the end of the year, you will need to repay $1,050.

The interest rate is expressed as an annual percentage rate, so if the loan term is longer than one year, you will pay that percentage on the remaining loan balance each year.

There are a number of alternatives to a personal loan. If you need some funds in the short term, there are low interest with no annual fee credit cards or cards with an introductory rate. If you want to access lower interest rates, a better option could be a secured loan or home equity loan.

The best product for you will depend on your needs and circumstances. It is always a good idea to check the terms and conditions and verify the total amount you can expect to pay. This will allow you to make an accurate comparison to determine the best choice for you.

This is determined by the type of loan and the lender. Borrowing from a fair credit borrower increases your chances of getting the funding you require because these lenders specialize in providing funding to people with poor credit.

You may also have a better chance of getting a personal loan from a credit union or an online lender. Because of the strict bank procedures and borrowing terms, banks are usually stricter on their borrower guidelines and have less room to work with you.

Most personal loans will require at least a 670 credit score. A credit score of 670 or higher ensures favorable loan terms and low interest rates. Personal loans are available from some companies with as little as a 620 credit score. They may be more interested, however. Before applying for personal loans, try to have a credit score of 600 or higher.

If your credit score is less than 600, you may be able to get a loan, but the terms will be less favorable.

This is determined by the amount of the loan. You can use our personal loan calculator where you can enter the amount of the loan and the interest rate.

You must also enter the loan repayment terms, which will be determined by the size of your monthly payment.

Knowing how much you will pay each month is critical when determining how much money you will need to budget to pay off your loan each month.

Some of the only fees that can be negotiated are origination fees. If you take out a large personal loan, you may be able to negotiate lower origination fees than if you take out a small loan.

To reduce the origination fees, you may have to agree to a higher interest rate. If you have previously worked with the lender and have a relationship with the bank that is providing you with the personal loan, you will be able to negotiate origination fees more easily because you have a relationship with the bank and can demonstrate that you are a good borrower.

Your circumstances will dictate whether you choose a secured or unsecured loan. If you don't have any security items, such as a home or a vehicle, an unsecured loan may be your only option.

However, if you are not in a hurry for the money and would prefer a better interest rate, you should look into secured loans. Just keep in mind that you'll need to be very careful to make all of your payments on time, because if you don't, your security item could be jeopardized.