A personal loan is helpful for a variety of situations, such as a wedding budget that is too large, debt consolidation or hospital bills. This versatility gives personal loans an attractive and ultimately dangerous aspect for borrowers.
No matter why you’re taking out a loan, you could have a debt burden of several hundred thousand dollars with higher interest fees if you don’t set up a repayment plan. Falling behind on payments – or worse, defaulting on a loan – can leave you looking bad in the eyes of the credit bureaus, which could prevent you from ever getting credit cards or renting apartments.
Before getting a loan, consider the following questions: Can I handle the debt? Did I get a good deal? What sacrifices would I have to make if I went into debt? Do I need a loan now?
Below we explain everything you must know regarding personal loans and why you ought – or ought not – to use them.
Definition of Personal Loans
As its name suggests, this is a one-time, fixed sum of money that gives you quick access to funds for personal use. A large portion of these loans is unsecured, which means that they have no collateral to back them up. Generally, they carry significantly more interest than secured ones, as they present a higher risk to the lender. But, as long as the borrower is unlikely to lose their assets (home or vehicle) in the event of default, non-secured loans are usually more advantageous to the borrower.
Regardless of the basic restrictions imposed by one’s loan provider (several companies that offer personal loans don’t authorize using their loans for commercial purposes, investments, housing or tuition), it can be used for almost anything. The most popular ways to use such a loan are consolidating debts, repairing a home, and covering unexpected expenses. However, remember that although they provide you with quick cash, they are not free. Their interest rates vary depending on your creditworthiness and terms and can be expensive for people with bad credit. Before you apply for it, ensure that you need it and have something in place to pay it back. And, according to your needs, you may consider other options, such as getting a payout from your credit card or taking out a home equity loan.
When To Take Out Personal Loans?
Consolidating debts
Consolidating debts from credit cards is among the everyday use of personal loans. LendingClub’s Financial Health Manager Anuj Nayar explains, “In our early days in 2008, we stood out as the best way to obtain credit for anything you wanted. That could be house improvements, travel, or anything else. We found that clients were primarily turning to us to consolidate their debt – a large majority of them want refinancing their credit cards to restore their financial health.”
With an average interest rate of 15% and more than 25% for specific cards, carrying debts on your credit cards quickly becomes costly and impossible. It makes it difficult to get out of it, and personal loans are a practical solution. To pay off the deficit, you borrow a fixed sum at a given rate and make a defined payment each month.
By planning your budget properly and setting up automated payments, you can manage your debt from a personal loan more quickly than from a credit card, which tends to have variable interest rates. In comparison, interest rates for personal loans range from 5% to 36%, subject to your credit rating and loan terms. However, as interest rates on loans can be easily higher than those on more expensive credit cards, this decision is only meaningful if you qualify for loans with smaller interest rates than the APR on your card.
A credit card balance transfer is an attractive alternative if your credit is good. Some cards charge a 0% annual interest rate for the initial period, usually 12-18 months, allowing you to move your remaining balances from another card for a single fee. If you are looking at consolidating your debt from a credit card, moving your balance can be like taking out a loan at 0% APR, assuming you repay the balance by the end of the initial period. High-interest rates will be charged to your credit card if you fail to do so.
If managing your debts is a challenge, starting by talking to your creditor is a good idea. Most of the time, lenders will cooperate with you if you are in trouble. Whether that means postponing payments, bargaining for a rate or minor monthly cost, or waiving charges, asking your lender for accommodation will smooth things out for you and your credit rating over time. You could also seek free credit counselors, who won’t pay you cash directly but will give you a hand in straightening out your finances.
House repairs
Another typical reason for borrowing money is related to home improvement in the form of renovations or repairs. If your roof is leaking, or you have termites or plumbing problems, it could be in your best interest to take out a loan to cover the enormous upfront cost and repay it later. But, if you’re planning to tear down walls to build a more open floor plan or dig up the backyard to put in a pool, ask yourself if this is an excellent argument for taking on a debt of a few thousand bucks and how much of a loan would be acceptable.
“Avoid excessive debt,” advises Farnoosh Torabi, financial columnist and presenter of a podcast called So Money. “No matter what type of debt you carry, such as personal loans, it’s best to keep it to less than 5 to 10 percent of your budget every month.”
At this point, having a plan – and the ability – to repay a loan is essential, more so for non-essential repairs that may be postponed for now. Getting a loan for long-planned maintenance may be more reasonable if you feel confident about your monetary solidity for the immediate future.
To get a higher loan and better interest rates, you can borrow an equity loan, a HELOC (Home Equity Line of Credit) or a cash-out refinancing. These options enable you to withdraw money from your house in various ways. However, remember that these options involve pledging your home as collateral, which can be riskier than taking out unsecured personal loans.
Funerals
First and foremost, the Funeral Consumers Alliance, a consumer advocacy nonprofit organization, advises against obtaining a loan to fund a funeral because of the elevated interest rates that these loans tend to carry.
The overall cost of funerals averaged $7,360 as of 2017, judging by the National Funeral Directors Association. That’s a tremendous sum for anyone, but mainly for those grieving their dear one’s loss and dealing with financial uncertainty. If funeral expenses cannot be covered outright or through life insurance, grieving relatives may choose a personal loan as a last option.
We recognize that a personal loan should be the last resource to cover funeral expenses. Still, if necessary, you should seek estimates from several lenders to obtain interest and terms that will save you additional hardship.
When To Avoid Taking Out Personal Loans?
Weddings
Based on WeddingWire’s 2020 Newlywed Report, newlyweds shell out about $30,000 to get married. This amount grows over time as essentials such as bridesmaids’ dresses, wedding gifts, and next-day brunches become essential purchases. Various services, such as caterers and wedding venues, automatically become more expensive if you say “wedding” even once. Thus, obtaining a loan is in people’s best interest to deal with the increasing costs.
However, we advise against getting into debt to finance a wedding. A debt load of $30,000 at the beginning of your marriage will put unnecessary pressure on this new stage of life and restrict your investment ability in a house, savings or retirement plans.
Vacations
Some individuals borrow money for travel (flights, hotels, tours, etc.) on a personal basis and pay for the costs in the following months or years. Before calling your local bank to request financing for a vacation to Venice or Lake Tahoe, be aware that such loans can be pricey and that interest costs are high for people with bad credit.
Returning from vacation can also be a rude shock, with a substantial bill and no money to repay. According to Nayar of LendingClub, a personal loan is recommended for emergency or financial recovery, not for “pursuing an Instagram style.”
Alternatively, work on saving up for your vacation over time, scoop up offers from airlines and travel agencies, and use your credit card bonus points to travel for free or at a low price.
Student debt
A personal loan can help consolidate various types of debt, including your school loans (although some lenders have reservations about this). However, it is usually only recommended if your academic loans are tied to exceptionally high rates. In most cases, school loans have cheaper rates than personal ones. If you switch your educational loan to a personal one, you will no longer be able to take advantage of deferments, forbearances or other payment arrangements. It is specifically true for federally issued school loans, which provide numerous protections that private lenders don’t offer.