For many, a personal loan can be an excellent tool to move forward with certain life goals. For others, it can be a hindrance that enables overspending and slows their financial progress.
All to say, there are pros and cons to personal loans. So, when is a personal loan a good idea—and when should you stay away? Here’s a rundown to help you decide if your situation warrants a personal loan.
How does a personal loan work?
A personal loan provides you the money you need to make a purchase you can’t currently afford (or don’t want to dip into your savings to finance). When you’re approved for a personal loan, the bank, credit union, or online lender will deposit a lump sum into your bank account. You’ll be set up on a monthly installment plan of equal payments until the loan is fully repaid—including interest.
Many lenders advertise fast funding, in some cases as early as the same day. Borrowing amounts are often capped at $100,000 or less (though there are exceptions).
The funds you get from a personal loan can be used for nearly any purchase, as long as it’s legal, and also to consolidate debt from other accounts like credit cards.
When a personal loan can be a good idea
Applying for a personal loan might be a smart money move when you’re looking to:
Fund a project that increases your net worth
If you can use a personal loan to increase your wealth, it can be a great idea. Fixing up your home to raise your equity, generating rental income by converting and improving a living space, even investing in specialized training programs to make yourself a more valuable professional can all be good uses of a personal loan.
Lower the amount of interest you pay for current debts
For those with good credit, personal loans tend to have reasonable interest rates compared to the likes of, say, credit cards. Many of the best personal loans offer minimum APRs below 7%, while the average credit card APR has been well over 20% over recent months.
A lower APR can potentially mean hundreds of dollars saved in interest, depending on the size of your balance and how long it takes you to repay what you owe.
If you’ve got credit card debt that you’re having trouble paying down due to the incessant interest payments, it can be a good idea to open a personal loan to pay off those high-interest balances at a more reasonable APR.
Lower your monthly debt-to-income ratio
Your debt-to-income ratio (DTI) is the amount of monthly income that you must use to pay off monthly debts. An auto loan, mortgage, personal loan, credit card bill, etc. all counts toward your DTI. A monthly income of $7,000 with $3,500 dedicated to paying monthly debts equals a 50% DTI ($3,500 in debt payments / $7,000 income = 50%).
Consolidating your debt with a personal loan can help you decrease your DTI. For example, if you’ve got considerable credit card debt, let’s estimate you might be paying $1,000 per month across multiple credit cards. But you could potentially pay off those cards with a personal loan charging monthly installments of just $600. This would drop your DTI by $400 in our scenario—and free up a substantial portion of your budget.
Decrease your credit utilization
On a similar note, personal loans are a great tool to drop your credit utilization. Credit utilization is one of the most important factors of healthy credit, accounting for 30% of your overall credit score. Put simply, it’s the amount of available credit that you’re currently using on your revolving credit lines.
Many experts recommend keeping your utilizatino below 30% to keep your credit score from being negatively affected. As an example, if someone with $50,000 in available credit across a few credit cards carries a $10,000 balance, their credit utilization will be 20% ($10,000 / $50,000 = 20%).
If you’ve got high credit card balances and your credit score is suffering, opening a loan to pay off your credit cards might improve your credit score in as little as a month or two. That’s because installment loan debt isn’t calculated into your credit utilization.
Pay for a large milestone expense
Life contains many important (and expensive) occasions for which you may not have the funds. From financing a wedding to paying for a funeral to adopting a child, these big life events often cannot be put on hold. Using a personal loan to foot the bill may be one of your better options.
Still, even important and necessary life events like these should be handled with financial prudence. Don’t give yourself a license to overspend just because something is once-in-a-lifetime.
Fund an emergency purchase
In addition to the predictable life events are myriad exorbitant unpredictable events. You may have emergency medical expenses, a leak in the roof, a large auto repair bill, etc. Opening a personal loan can help you to get what you need immediately and figure out the details later.
When a personal loan can be a bad idea
You’re buying something you don’t need
A personal loan is a financial burden that you may carry with you for a long time. Yes, it gives you the option to make a purchase that you can’t currently afford with cash—but you’re using it for a discretionary purchase, like electronics, a vacation, etc., you may find yourself with buyer’s remorse years from now when you’re still making monthly payments.
All to say, using a personal loan to satisfy a desire that could be budgeted for with time and patience is not a wise use.
Interest and fees are high
Using a personal loan for expenses is only wise if you’re getting good loan terms. If you can find a cheaper way to finance your purchase, do that instead.
For example, if you’re offered a personal loan with 30% APR, a steep origination fee, and early payoff fees, you’re probably better off making the purchase with a credit card or other alternative (we’ll cover those in a minute).
You tend to overspend
Again, one of the best uses of a personal loan is to consolidate your current debts. But for an impulse spender, this could actually do more harm than good.
When you use a personal loan to pay off your credit card debt, you become vulnerable to repeating the same mistake again. Rack up debt on your credit cards, and you’ll now have something like double the debt. A personal loan can’t change your impulses—but it can exacerbate their consequences.
Pros and cons of a personal loan
Pros
- Typically reasonable APR for those with good/excellent credit
- Often quick funding
- Use the money for (nearly) anything
Cons
- Interest is unavoidable
- Credit score will sustain a slight (temporary) drop upon account opening
- Some banks ding you with origination fees, early payoff fees, etc.
Alternatives to a personal loan
A personal loan doesn’t suit every financial goal. Here are some other options for funding your expenses:
- Credit cards: Better for everyday expenses than a large purchase, credit cards tend to come with less favorable APR than a personal loan. We recommend paying your card off in full every statement cycle. That said, some cards come with a 0% intro APR offer for a year or even close to two—a great option for big-ticket items if you can manage to pay off your purchase within that time frame.
- Borrow from your home equity: Homeowners may do better with either a home equity loan or home equity line of credit (HELOC). Interest rates may be lower, and your borrowing amount may be higher (depending on the amount of equity you’ve built). Just note that this loan is secured by your home, meaning you could lose your property if you default.
- Borrow from friends and family: Less formal and with fewer official application requirements, borrowing money from those close to you can be the cheapest way to finance a purchase.
The takeaway
Taking out a personal loan is likely a good idea when you’re either funding something that should ultimately increase your net worth, trying to pay down debt faster by consolidating balances, covering an emergency expense, or even paying for one of life’s important events (like a wedding).
But, if you’re using the money to buy something recreational, consider waiting until you’ve saved the cash. This will help you to avoid paying interest and help you avoid overspending.
Frequently asked questions
Is it smart to take out a personal loan to pay off credit card debt?
In terms of lowering the interest you pay each month and decreasing your monthly payments, taking out a personal loan to pay off credit card debt can be smart. Just make sure you’re not prone to overspending, or you could find yourself with a whole lot more debt later.
What credit score do you need for a personal loan?
Most loans demand at least a “fair” credit score (580 or above, per FICO). However, you’ll likely not be approved for a loan with favorable borrowing amounts and interest rates. For the best personal loans, wait until your credit score is at least “good” (670 or higher, per FICO).
How quickly can you get a personal loan?
You can get a personal loan as quickly as the same day with some lenders.
Can I pay off a personal loan early?
You can pay off a loan early—but a select few lenders may charge an early repayment fee. Read your loan terms to see if you’re subject to this ridiculous fee as you decide whether it’s worthwhile.
What’s the difference between a secured and unsecured personal loan?
A secured personal loan requires collateral to open. The bank will require that you give them a security deposit that it can use to pay off your debt in case you default. This may be a car, jewelry, etc.
