Cash News
A personal loan is a consumer loan that you can use for just about anything: debt consolidation, covering emergency expenses, paying for a wedding, renovating your kitchen … If you have a financial problem to solve, there’s a good chance a personal loan can help.
Unlike mortgages or auto loans, personal loans are unsecured and often don’t require collateral (like a home or car). Plus, with much lower annual percentage rates (APR) than credit cards, a set payoff schedule and fixed monthly payment amounts, it’s easy to see why personal loans are a popular choice.
Still, taking on new debt is a major financial decision, so make sure you have a genuine financial need, weigh the pros and cons and consider whether there are other, better options for borrowing money.
Pros and cons of personal loans
Personal loans can be helpful in a pinch, but they have their drawbacks.
While they can give you quick access to extra money and may offer lower interest rates than other financial products, they also come with fees and interest and have the power to negatively impact your credit score.
Pros:
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Personal loans offer quick access to funds: Approval and funding times vary across personal loan lenders, but in many cases funds can be made available within a few business days. Some lenders even offer same-day or next-day funding.
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Personal loans usually offer lower APRs than credit cards: Recent data from the Fed shows that in August 2023, the average APR on a two-year personal loan from a commercial bank was 12.17%. That’s compared to the average credit card APR, which currently stands at 22.77%.
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Personal loans can be used for almost anything: Unlike a home or car loan, you don’t have to designate a specific loan purpose. You can use a personal loan to cover medical bills, home improvements, debt consolidation, and more.
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Personal loans are unsecured and don’t require any collateral: In the event that you default on your loan, there’s usually no asset that your lender can claim. This does, however, mean that your APR may be higher than it would be on a secured loan because your lender is assuming a greater risk.
Cons:
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Personal loans come with their own fees: Throughout the processing and repayment period, you may encounter interest fees, origination fees, late fees, and even an early payoff penalty.
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Your credit score will take a hit if you make late payments or default: Like any other debt payment, missing a personal loan payment can negatively impact your credit score. If you struggle to manage debt, this could be a slippery slope.
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A personal loan won’t cover you in a future emergency: When you borrow a personal loan, you’re given a lump sum upfront. If you need more money later, you’ll have to take out another loan or better yet, tap your emergency fund.
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It’s harder to get approved for a personal loan: Unlike a payday loan lender, personal loan lenders run a credit check before approving you, and you need good credit to qualify for the best personal loan rates.
3 questions to ask yourself before applying for a personal loan
While you may qualify for a personal loan in your lender’s eyes, deciding to apply for a personal loan shouldn’t be taken lightly. You should consider how a personal loan fits into your greater financial plan. Ask yourself:
1. Do you have a real financial need?
Ask yourself whether you truly need this new loan and how urgent that need is. If you find yourself in a medical emergency and need quick access to funds, a personal loan could be your best bet.
However, if you want to finance a purchase that isn’t a pressing emergency, say a cosmetic home improvement, you could be better off saving money in a high-yield savings account or CD for that expense. That way, you’ll save money on the interest you would’ve paid on a personal loan.
2. Will you be able to repay your personal loan?
A personal loan will add an extra monthly payment to your budget and reduce the amount of money you have available each month to cover your expenses, debt payments, and savings goals. And keep in mind, personal loan terms range from two to five years. So be sure you’re ready for that commitment.
Borrowing money you’re not able to repay can ultimately hurt your credit score and your chances of borrowing in the future.
You should consider this when determining your loan amount and repayment terms. A larger loan will likely take longer to repay and come with higher monthly payments.
3. Are there more cost-effective alternatives?
A personal loan can sometimes be the best option if it saves you more money over time. Say your goal is debt consolidation to wipe out your high-interest credit card debt. If your APR is 21.19%, the current average, and you’re able to get a personal loan with a 10% APR, you could benefit from taking out a personal loan and paying off your credit card debt sooner.
In other instances, a personal loan might not be the best option for debt consolidation. Federal student loans, for example, carry average rates between 5.50% and 8.05%. In this case, using a personal loan to consolidate that debt would actually be more costly.
Ultimately, a personal loan isn’t free and will only give you a certain amount of money to work with. You can also expect to pay fees and interest anytime you borrow money. If you aren’t sure you want to assume the responsibility of a personal loan or if it’s the most convenient option, other alternatives could make more sense:
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High-yield savings account: Best for saving up to make large purchases. You earn a good rate on your savings and avoid paying interest on borrowed funds.
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Certificate of deposit: Similar to HYSAs, CDs pay a fixed interest rate on the money you put in, making them ideal for achieving short-term savings goals. One drawback: your money is tied up until the CD reaches its maturity date.
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Home equity loan: Great for financing home improvements by tapping into the equity in your home.
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Home equity line of credit, aka HELOC: Similar to a home equity loan, except a line of credit is open-ended, letting you pull cash from your home’s equity as needed.
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Credit card: This can be a great option for making a big purchase if you trust yourself to pay off the balance and use the card responsibly. You can also avoid interest charges or pay off other high-interest debt by using balance transfers to cards with 0% introductory interest rates.
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Payday loan: Only for the most dire emergencies or to pay for basic expenses when you’re out of money. These loans carry extraordinarily high interest rates and fees.
4 key factors lenders consider on your personal loan application
Without collateral, financial institutions will assess your creditworthiness and thoroughly review your personal finances before deciding whether to give you a loan.
Keep in mind that every lender has their own requirements, as well as the level of risk they’re willing to take on, but this general list will give you an idea of what to expect.
1. Loan amount and purpose
Personal loans offer more flexibility than other types of debt, but you should still be reasonable in your ask. Lenders want to ensure that you earn enough to cover the payments for the amount you’re asking to borrow and may have restrictions about how much they can lend.
2. Credit history
Your credit report is like your financial track record. Do you have a history of managing credit responsibly?
While excellent credit is not required, lenders use your credit history and score to make an approval decision. Fortunately, bad credit won’t necessarily exclude you from qualifying for a personal loan, but good credit is generally rewarded with better APRs.
3. Income
Lenders such as banks and credit unions want to make sure you have a steady stream of income and the means to make your loan payments through the end of the term. You’ll likely be asked to provide proof of income, like recent pay stubs or W-2s, so your lender can verify you’re employed and meet their income standards.
4. Debt
Specifically, lenders want to know how much debt you already have compared to your gross income. This is called your debt-to-income ratio, or DTI. A lower debt-to-income ratio means you have less debt relative to your income.
Lenders often have debt-to-income ratio limits for each type of loan. For example, mortgages generally require a DTI of 36% or below, but there are lenders that accept DTIs above that value. It’s all relative to the rest of your application.
If it seems like you’re taking on more than you can comfortably afford to pay back, this could give your lender some pause about extending you a new loan. To calculate your debt-to-income ratio, simply add up all of your monthly debt obligations (mortgage, auto loan, student loans, etc.) and divide them by your gross monthly income.