A personal loan can be more cost-effective than a credit card to finance certain purchases. The more you understand about personal loans and how they work, the better prepared you should be to use the tool wisely.
What is a personal loan?
A personal loan is a form of unsecured debt -- generally money from a lending institution such as a bank, credit union or online lender -- that is paid back in monthly installments over a defined period of time. A good way to understand personal loans is to think about where they fit in with other borrowing options in terms of their restrictions.
Credit cards: fewest restrictions
A credit card gives you the most freedom as a borrower. You can access credit whenever you want, for a wide variety of purposes and -- as long as you make each month's minimum payment -- you can vary how long you take to pay back the debt. The catch is that, on average, credit card debt is more expensive than other forms of debt. So this type of borrowing is best used when you are able to pay it off fairly quickly.
Personal loans: moderate restrictions
Personal loans fall somewhere in-between credit card debt and mortgage or car loans. Can you use a personal loan for anything? Like credit-card borrowing, personal loans typically don't restrict how the money is used. In addition, they are usually unsecured, so collateral is not required. Personal loans do have structured repayment terms, but these are typically shorter than for mortgage or car loans (often three to five years for a personal loan, compared to four to eight years for car loans and 15 to 30 years for mortgages).
Auto loans and mortgages: most restrictions
Mortgages and auto loans are much more structured. They are used for a specific purchase, and the repayment term is defined. Repayment terms are typically designed to allow you to stretch payments out over a period of several years -- or even decades in the case of a mortgage. Because these types of loans are secured by collateral (i.e., the house or car being purchased) lenders can offer much lower interest rates than they do on credit cards.
What is a good reason to get a personal loan?
Personal loans can be used for a variety of purposes, from paying for vacations to financing a major purchase. Some of these purposes are better than others, so how do you determine what is a good reason to get a personal loan?
Let the repayment term of the loan guide you. If you get a loan that will take three to five years to repay, it should be for a purpose that has a benefit that lasts at least that long. Otherwise, you may find yourself in a cycle of continual borrowing in which you never fully pay down your debts, let alone get a chance to start saving for the future.
In other words, personal loans are best used for out-of-the-ordinary, long-term purposes, and only when you can fit the loan payments into your budget.
Getting a personal loan to pay off debt
Personal loans are often used to consolidate or pay off existing debt. Combining multiple debts into one monthly payment helps make debt easier to manage overall. Also, since personal loans generally have lower interest rates than credit cards, this tool can be used to reduce your interest expense.
Do debt consolidation loans hurt your credit?
Not in and of themselves. Personal loans with attractive interest rates may help you pay off credit card debt more rapidly and therefore help your credit rating in the long run. Unfortunately, if your debt burden has already damaged your credit, it may be harder to get a personal loan rate that is significantly lower than what you are already paying on your credit cards. Keep in mind that you should only use a debt consolidation loan as part of a budget discipline designed to reduce your overall debt over time.
What is a good credit score for a personal loan?
Many factors go into getting a loan approved, such as the size and stability of your income. Many people wonder "How much do you have to make to get a personal loan?" There is no one income level that is used for personal loan qualification.
Your credit score is pivotal not just in whether or not you get approved, but also in how favorable the personal loan terms (such as interest rate and length of loan) are.
Each lender has its own standards, but here are some general credit-score thresholds that could affect your borrowing experience:
- 740 and above (on a scale to 850)
This is considered very good to excellent credit. It should be easy for you to qualify for the most favorable loan terms.
- 670 to 739
In this range, your credit is considered middle of the road, so you should be able to qualify for a loan with roughly average loan terms.
- 580 to 669
This is considered sub-prime borrower territory. If you do qualify for a personal loan, it is likely to come with a steep interest rate.
- 579 and lower
Personal loans for bad credit may be attainable, but below this threshold, you should really think twice before borrowing. It means you may already have a debt problem, and any further borrowing is likely to be at interest rates that only make the problem worse.
There are many lenders out there, so be sure to shop around before choosing a personal loan. Compare rates that are specific to your credit score and situation, and review the repayment schedule carefully to make sure you can afford those payments.