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5 Personal Loan Myths You Should Stop Believing

| MoneyRates Personal Finance Specialist.
min read

money-cogsBelieving personal loan myths could cause you to pay too much for financing. Or mismanage your debt. So here are five facts you must know about personal loans before choosing any type of financing.

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Myth#1: Excellent Credit Required

Personal loans are available for people with many grades of credit. Naturally, if your credit is angelic, there will be more choices available and you'll be able to shop for a loan more aggressively. Lenders offer their best rates to applicants with the best credit.

But only a small part of the population has the "best credit." And yet most people are able to borrow in some capacity. Some personal loan lenders specialize in loans to those with lower credit scores or other difficulties. The main hurdle you'll face with these companies is affording the payments. Your debt-to-income ratio will have to meet guidelines (most likely 50% or lower).

Interest rates vary widely, so it's very important that you get quotes from a number of competing providers. Don't be intimidated because your credit score is low and take the first offer you get. Shop and compare products from companies that work with consumers with credit ratings like yours. (That goes for all consumers, in every credit score tier.)

Beware of "personal loans with no credit score" advertised online and elsewhere. They are NOT personal loans. Many payday and title lenders masquerade as personal loan vendors. You'll know these fakers by their crazy claims and extremely short terms (two weeks to a month). And you'll pay very high interest rates and fees. (An online search turned up loans with APRs as high as 3600%!) Don't go there unless you want to spend your life in a cycle of debt, refinancing your loan again and again as your balance grows ever higher.

Myth #2: Interest Rates Are Sky High

As of this writing, the average interest rate for personal loans is just under 11%. That's more than most mortgages or auto loans, but those are completely different products. Mortgages and auto loans are secured loans. When you borrow to buy a home or car, you pledge that asset as security to the lender. Which means the lender can repossess or foreclose if you don't repay the loan. And take your car or home.

That added security means you pay a lower rate for secured financing. The loan that more closely resembles a personal loan is the credit card. There is no security and the card issuer only has your promise to repay the loan. So credit card issuers charge higher interest rates to compensate themselves for the added risk.

How much higher? Average credit card rates, as of this writing, run about 7% higher than those of personal loans.

But if your credit is excellent, some personal loan vendors offer interest rates that come very close to those of home equity loans. Without the home appraisal, title insurance, escrow services and other costs. And you don't need home equity and your house is not on the line.

Finally, while most personal loans are unsecured, you may be able to get a reduced interest rate if you're willing to put up an asset (called collateral) as security for the loan.

Myth #3: You Can Blow Off an Unsecured Loan

What happens if you don't repay your personal loan? The lender cannot repossess your car. You won't come home from work to find a foreclosure notice on your door. And if you make the request in writing, bill collectors cannot call you. Final notices can be tossed in the trash and you can filter emails in seconds.

So it's not that hard to borrow and default on an unsecured loan, right?

Wrong.

Your lender's security is your promise to repay. And there are ways of enforcing that promise. Lenders can refer your account to a collection agency or their own collection departments. They can sue you and obtain a judgment - which, by the way, is a public record for all future lenders and employers and landlords to see.

And once the lender has a judgment, it may be able to garnish your wages, place a lien on your home or empty your bank account. That's up to your state laws and the judge.

Myth #4: Personal Loans Play Hard to Get

In fact, applying for a personal loan is fast and easy. You can do it online. And you can get your money in just days and sometimes hours.

To put this into perspective, go spend a few hours in an auto dealership with the financing desk and you'll see how fun that process is. Or spend 30 to 45 days waiting for a mortgage approval after providing a DNA sample and references from your last two exes and your babysitter (that's exaggerating, but only a little).

In most cases, you complete a short form, upload proof of income and your identity and address, and wait a few hours for a decision. If you work with sites like MoneyRates, you can provide your information to more than one lender, get a few offers and choose the best one. it doesn't get much easier than that.

Myth #5: Applying for a Personal Loan Hurts Your Credit Score

Some consumers believe that adding debt automatically decreases their FICO score. That's likely because a new account drops the average age of your accounts. And credit inquiries for personal loans do temporarily drop your score by about five points.

If you have a bunch of maxed-out credit cards and then you apply for a personal loan, your FICO is likely to head south. And adding more debt when you already have many open accounts with balances is a red flag and can hurt you.

However, if you use a personal loan to consolidate those maxed-out credit cards, you can increase your score - and do it fairly quickly. That's because credit scoring models count installment debt like personal loans differently than they do revolving debt like credit cards. When your credit card balances are high compared to your credit limits, your FICO takes a hit. When your revolving balances exceed 30% of your credit limits, your score falls.

But when you use a personal loan to pay off your credit cards, that percentage, called your "utilization ratio" drops to zero. Stop carrying credit card balances once you have moved that revolving debt to an installment loan, and your finances and credit score will get healthier every month.

And if you have very little information on your credit report, a personal loan can also increase your score. That's because you can be penalized for using too little credit as well as too much. Paying off a personal loan on time can add good credit history and raise your FICO score.

Personal Loans: Sometimes They Really ARE the Best

If you already have a home equity line of credit, it might be a cheaper source of funds than a personal loan. Low-interest loans or grants from government or charitable organizations, when you qualify, can be the best for home repair or a down payment. And people with serious debt problems may need more help than a personal debt consolidation loan can offer - like debt management or credit counseling.

However, many other consumers find that personal loans are the best way to finance many things. Personal loans usually come with fixed rates that are substantially lower than credit card rates. So if you can get a lower interest rate and afford a payment that will clear higher-interest debt, a personal loan can help get your finances back on track.

Personal loans beat credit cards for large purchases when their interest rates are lower. And fixed rates and payments make budgeting easier. You can use credit cards to get rewards or a low introductory rate, then pay them off with a personal loan before the higher interest kicks in.

If you don't need a huge amount of cash, personal loans can be more economical than home equity loans, even if their interest rates are higher. It depends on the home equity loan setup costs, which can be similar to those of a mortgage.

The reason there are so many loan products available is that there are many different needs. Just do your homework and match your financing to your situation. That way, you'll pay less for everything you finance.

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