You’ve been contemplating a personal loan, but is it a smart choice? If you’re working toward getting your finances in order, then at first glance, taking on more debt might seem like the wrong strategy. Even so, there’s still a glimpse of hope. A personal loan may turn out to be the best financial tool to help keep you from racking up more debt in more perilous ways—like maxing out on your credit card balance or taking out a payday loan—while simultaneously helping with your debt management efforts.
What is a Personal Loan?
By definition, a personal loan is an installment loan extended to you by a financial institution. The term “installment loan” suggests that this type of loan typically comes with set terms up front, including:
- The total amount you’ve been granted or loaned
- How long you have to pay back the loan
- How much your fixed monthly payment is
Installment debt can help you make progress toward paying off your total debt load. Conversely, revolving credit, such as credit card debt, may see you pile up more purchases, making your debt load even larger. And since you’re making variable payments, it may appear as if you’re making payment after payment without seeing any progress toward payoff.
Personal loans often come in two options: secured and unsecured. A secured personal loan is usually backed by collateral—think of a mortgage that’s secured with your house as collateral or a personal auto loan where your car serves as the collateral. Most lenders offer secured personal loans because they know that they can repossess the item that’s securing the loan if you fail to honor your payment schedule. And that’s something you really need to consider: what would happen if your financial situation changed? Would you be at risk of losing your collateral asset?
By contrast, unsecured personal loans don’t need collateral. Your lender puts faith in the fact that you’ll continue to responsibly pay back your debt as you’ve done in the past—that’s why you’ll probably need a good credit score to be approved. An unsecured personal loan may also carry a higher interest rate since your lender is taking a huge gamble by loaning you money that isn’t backed with an asset.
When is it a Good Idea to Take Out a Personal Loan?
Everyone’s life is different, and the list of potential uses for a personal loan is nearly endless. Here are prime circumstances when taking out a personal loan might be a good idea.
Build or support your credit score
When used responsibly, a personal loan can help you build and maintain a good credit score—especially if you’re bogged down by a history of missed payments on other debts. There are three primary ways a personal loan can help build your credit score.
First, your lender reports your on-time payments to the three major credit bureaus. Most personal loan lenders will forward your balance and payment activity to all three credit reporting agencies each month. Negative reports (like missed payments) will drag your score down, while positive reports (like on-time payments) help bolster your credit score. And if building your credit history is also important, ask your lender whether they make monthly credit bureau reports before taking out a personal loan.
Second, a personal loan can help you build your credit score if it diversifies your credit mix. As mentioned earlier, a personal loan gives you money that you pay back in equal installments over a fixed period. However, revolving credit like a credit card account can be used and paid down repeatedly. Therefore, if your primary source of credit has been from credit cards, bringing in a personal loan would diversify your credit mix, which could improve your credit scores. However, keep in mind that taking out a personal loan still means you’re racking up debt. A good credit mix will not help raise your credit scores if you can’t keep up with the required payments.
Consolidate multiple debts
Remitting payments to multiple lenders each month can be a pain, not to mention the expensive toll on your finances if some of those debts have a high interest rate. Luckily, a single personal loan could be your reprieve if you’ve been juggling multiple loans or monthly repayments.
Consolidating debt simply means combining multiple debts from credit cards, high-interest loans, and other bills into a single monthly payment. A debt consolidation strategy may lower your interest rate, lower your monthly payments, and help you pay down debt faster. And depending on your eligibility, you may be in a position to borrow just enough money to repay all your pending bills.
Refinance your high-interest debt with a low-interest personal loan
On average, Americans carry about $38,000 in personal debt. But don’t let that put you off, as you can potentially pay less in interest on your debt by taking out a personal loan. Let’s face it; a personal loan is one of the most affordable ways to borrow money. Personal loan rates (such as mortgage rates) are usually much lower than the rates on credit cards, private student loans, and most other loan types. A personal loan lets you pay off your high-interest debt and convert it to a lower interest rate.
Let’s put into perspective how much money you can potentially save in interest when you take out a personal loan. Say you’re carrying a $100,000 mortgage loan with a 3.5% interest rate and a $10,000 credit card debt with a 17.78% interest rate. In one month, your mortgage racks up about $291 in interest, while your credit card debt accrues $148 in interest.
Now, what if you refinance your $10,000 credit card debt into your $100,000 mortgage? Your new loan of $110,000 retains its 3.5% interest rate, so the $10,000 credit card debt accumulates about $30 in interest rather than $148. You’ll save more than $100 in interest per month by paying off the high-interest card debt and rolling it into your personal loan.
When is a Personal Loan a Bad Idea?
There are some instances when taking out a personal loan may not be a financially sound move, particularly when it involves wants instead of needs. Taking out a personal loan is a bad idea in the following scenarios:
When you’re just going deeper into debt
Getting approved for a personal loan might be a long-awaited milestone in your financial journey, but it could leave you stranded in a quagmire of debt. At it’s core, a personal loan simply means you’re borrowing more money. Taking out a personal loan to pay off your credit card debt is smart, but if you start carrying balances on those cards again, then you’re just adding on to the debt you had before.
Remember, a personal loan for debt consolidation doesn’t eliminate your debt outright. Only run the gauntlet if you’ve assessed and exhausted other options, like increasing your credit card payments or opening a balance transfer credit card.
When the bank might not lend to you at a favorable rate
Although personal loans typically have lower interest rates compared to credit cards, that might not always be the case—for example, if you have less-than-stellar credit scores or if you typically would not qualify for a loan. And if you do happen to qualify for a personal loan despite having bad credit, the interest rate your lender offers may not be any lower (and could be higher) than what you’re already paying.
In this case, it’s far more prudent to save on interest charges—or forgo them outright—than rack up additional debt for something that doesn’t hold inherent value. Even when it may be a better option to accruing more credit card debt with potentially higher rates, you’ll still be on the hook for some interest charges.
How Do I Get One?
Getting a personal loan is much easier than you might think; in fact, it’s very similar to the credit card application process. The first step toward getting a personal loan is checking your credit score. Similar to credit card issuers, personal loan companies will assess your credit when you apply to determine whether you qualify. The higher your score, the more loan options you’ll qualify for and the better the terms you’ll be offered.
Once you know where your credit score stands, it’s time to comparison shop personal loan offers. Pay attention to the credit requirements for each loan and narrow them down to what you will likely qualify for. Then start comparing other aspects, like interest rates, loan amounts, estimated monthly payments, and timeframes, as these can vary significantly by lender.
After narrowing down your options to the personal loans that carry the best terms, it’s time to proceed to pre-qualification. Pre-qualification is usually a way to check how likely you are to be approved for a personal loan without actually getting into the paperwork. You just need to furnish your lender with some basic personal information and you’ll have your status revealed. Importantly, a pre-qualification won’t ding your credit score. Also, even though you’ve been pre-qualified for a loan, it doesn’t necessarily guarantee approval—though your chances are about as high as they can get.
By now, you should have made a decision on which loan option to go with. Be sure to fill in your application online, as this will likely have the fastest decision turnaround. The application will ask you to provide basic personal information like your name and address, and financial information like your employment status and current income, so be sure to fill out everything truthfully and accurately.
Next you sit back and wait for a decision. It could happen within hours or several weeks, depending on how well you meet the loan’s income and credit requirements and how quickly the lender verifies your personal information. If you’re approved, your lender should notify you and send a bank transfer for the loan amount.
Conclusion and Recommendation
There are numerous ways a personal loan might come in handy. Whatever life throws your way, a personal loan can be your ticket to staying afloat financially. On the flip side, if you take out a personal loan to pay off debt, your amount owed may not change much, since you’re technically borrowing the amount you need to clear the old debt.
And while personal loans will serve any purpose, they may not be the most convenient or affordable option for your financial circumstances. Other credit options to potentially explore include balance transfer credit cards, a home equity line of credit (HELOC), or even a salary advance.