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Pros and Cons of Personal Loans

| Money Rates Columnist
min read

good-or-bad-people-cheeringPersonal loans are not good or bad. Like money, personal loans are neutral. They are either right for you or wrong for you depending on your circumstances. And on your reason for borrowing.

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What Is a Personal Loan?

A personal loan is generally a form of unsecured financing with a fixed interest rate and a set term. The result is that the borrower makes a regular monthly payment for the life of the loan. If you need $5,000 from a bank, credit union, friend, or family member, the cost over three years at 10% interest will be $161.34 per month.

This quick and neat definition of a personal loan tells us what's largely true, but not true in every case. There are secured personal loans and personal loans with adjustable rates.

Reasons to Get a Personal Loan

There are many reasons to get a personal loan. While you can borrow for just about any reason (the lender doesn't usually care), there are better and worse reasons for taking on debt. For instance:

  • Pay for a party or vacation
  • Buy a car needed for work
  • Finance an education
  • Start a business
  • Consolidate high-interest debt
  • Save on travel by paying in advance
  • Pay for a wedding
  • Pay off tax debt
  • Finance an investment

And so on. While personal loans are private decisions and highly-individual, in most cases, you want to match the debt to the purpose. Financing a weekend bash with a three years loan probably doesn't work for most people. Financing a well-considered investment might be easier to justify.

Does a Personal Loan Make Sense?

Other factors that determine if a personal loan is good or bad depend on your ability to repay it and the consequences of taking it on. Consider:

  • Your personal needs and preferences
  • The cost to finance
  • The type of loan
  • Your credit standing
  • Your ability to budge and save
  • The reliability of your earnings
  • Your current debt levels
  • The value of a property with a secured loan

Personal loans can be a sensible part of your financial picture if you consider these items first, shop for the best deal and make an informed decision.

Personal Loan Advantages

Personal loans are a widely-used form of financing because they work for many borrowers. They can offer a number of advantages.

Personal loans are available from a wide range of sources including banks, credit unions, friends, and family.

Rates and terms vary. Because not all personal loans are alike - or equally attractive - you'll do best by shopping around for the best rates and terms. But personal loan interest rates usually run several percent lower than those of comparable credit cards.

Personal loans are generally not secured. You typically do not have to pledge your house or home as security. This also means you do not have to own a home or car to get financing. It also means you won't lose your home or car to your personal loan provider if things go south financially.

Personal loans can allow you to take advantage of sales and discounts because you have the cash in hand to make a buying decision.

A personal loan can help raise your credit score because it's an installment loan, not a revolving account like a credit card. Personal loans with fixed interest rates and payments make budgeting easier. With payments in full and on time, a personal loan will show a good use of credit.

Personal Loan Drawbacks

Financial products are neutral. There rightness or wrongness depends on who uses them, how much they cost and to what use they are put. (Obviously we are talking about mainstream, regulated financial products and not loan sharking or other questionable lending here.)

Financial products are neutral. There rightness or wrongness depends on who uses them, how much they cost and to what use they are put. (We are talking about mainstream, highly-regulated financial products and not loan sharking, payday loans or auto title loans.)

Although simple personal loans - financing with a fixed rate and a set term - are generally safe financing bets, some personal loans can have shortcomings.

First, a particular personal loan may simply be the wrong financial product for your needs. For instance, given your credit, debts, and income a lender who wants 12% in a 10% market should be avoided.

Second, personal loans can be bad if you don't control your spending. Many people who consolidate debt with personal loans fail to change the habits that got them into debt in the first place. They end up running up their credit card balances again. And now they also have a debt consolidation loan to cover. Loans that make it easier to spend more than you earn can be "bad" even though they are technically neutral.

Third, personal finance experts generally agree that short-term needs should be financed with short-term loans. Want to take a vacation next year? You may be able to save half the cost if you pay for it now with a personal loan. But don't finance it over five years - take a one-year loan. Unless you want to skip trips for five years because you're still paying for this one.

How Does a Personal Loan Affect Your Credit?

With the act of applying for a personal loan the credit system is aware that you have made a credit inquiry. How and when you pay or don't pay your loan will impact your credit score, thus influencing the cost and availability of future financing.

A look at the widely-used FICO-brand credit scoring system explains how the use of a personal loan can impact your credit score.

The FICO system uses five factors to establish credit scores.

  • Credit inquiries (10%)
  • Payment history (35%)
  • Level of debt (30%)
  • Age of credit history (15%)
  • Types of credit (10%)

So here are some potential ways applying for and getting a personal loan might affect your credit score:

  • You will have one or more inquiries from lenders. That temporarily drops your credit score.
  • If you're adding to your debt load, that may also drop your score (it depend how much debt you're already carrying and how many open accounts you have).
  • If you're consolidating credit card debt with a personal loan, it can increase you FICO score. That's because carrying credit cards balances, especially if you're using more than 30% of your available credit, harms your level of debt or utilization. Paying off those accounts with a personal loan drops utilization to zero.
  • Adding an installment account can improve your types of credit or mix of credit if you only have revolving accounts like credit cards. Credit scoring models treat installment loans and mortgages "better" than credit cards.
  • Paying your account faithfully on time builds good credit history. And that (35% of your score) is the most important factor of all.

For many people, personal loans can have a positive affect on credit scores. But not if you're carrying a lot of debt and seeking to add to it.

When Are Personal Loans Bad?

Personal loans are bad when you can't afford them, or when you use them for the wrong purpose. Borrower's remorse is a real thing. If you use personal loans habitually to spend more than you earn, they are facilitating bad financial behavior and are therefor "bad."

Personal loans are less-than-good if there is a better or cheaper option and you don't take it. For instance, if you can clear a small debt in less than a year and qualify for a credit card with zero interest for 12 months, why would you take a one-year personal loan with a 10% rate and $200 in fees?

When Are Personal Loans Good?

Personal loans are good when they produce a material benefit in your life or finances. If the use of a personal loan allows you to consolidate high-cost loans into financing with a lower rate that's good, especially if you also adopt a budget and lower overall debt levels. Personal loans are great if they allow you to buy something you want at discount because you have funds available. And personal loans are good if they allow you to move forward in life. For instance, you might want to use a personal loan to finance an auto purchase at a lower cost.

What Are the Alternatives to Personal Loans?

There will be situations where a personal loan is not your best financial option. For instance, if you own real estate and have "tappable" equity, you might prefer to get a home equity line of credit (HELOC). Overdraft protection for a checking account is typically free or cheap and will save you from high-cost overdraft fees. And, of course, one alternative is simply not to borrow, to save until you no longer need loans for your ongoing financial needs.

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