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4 ways you can use a personal loan and when to avoid doing so

December 9, 2022, 2:40 PM UTC
Photo illustration of a bride and groom wedding cake topper sitting on a bag of money.
A personal loan can come in handy to cover some of your bigger expenses.
Photo illustration by Victoria Ellis/Fortune; Original photos by Getty images

When you’re in a pinch (or your emergency fund or savings account isn’t as padded as you need it to be), a personal loan can come in handy to cover some of your bigger expenses. But, fair warning: Personal loans are not a free-for-all, and you should have a specific goal in mind when taking out a personal loan. They may also come with their own limitations depending on your lender (more on that later). 

Still, personal loans can be a viable option for nondiscretionary expenses like debt consolidation, purchasing a car, and more. 

What is a personal loan? 

A personal loan is a loan, typically offered by a bank, credit union, or other financial institution, that is provided to customers in one lump sum and repaid in installments over the course of one to five years—although some may offer terms as long as seven years. Personal loans may fall into a few different categories depending on their eligibility requirements. Here are a few key terms you should know before considering one: 

  • Secured loans: These loans require you to put down collateral in order to qualify for the loan. This may be your home, car, or some other asset. 
  • Unsecured loans: These loans don’t require you to put down any collateral or a signature from a co-signer in order to qualify. 
  • Debt-to-income (DTI) ratio: How much you owe in debt payments each month, compared to how much you earn. Lenders will consider this when deciding if they want to approve you for a loan and it helps them determine your loan amount and terms.
  • Origination fees: An upfront fee you’ll pay to your lender for processing your loan. 
  • Repayment term: This is the amount of time you’ll have to repay your total loan amount. 

How do you get a personal loan?

Getting a personal loan is a fairly straightforward process. However, you’ll want to make sure that your current financial standing is in a good spot so that you’re able to secure the loan you need with the most favorable terms. 

1. Check your credit score: Your credit score matters, and lenders will use it to determine the likelihood that you’ll be able to repay the amount you borrow. Before you apply for any loan, check your credit report and see if there are any factors that could be dragging down your score. 

2. Prequalify with multiple lenders to compare your options: Don’t settle for the first personal loan you look into. Contact multiple lenders for a prequalification to figure out how much you’re eligible to borrow and what the terms may be. This can help you determine where to get the best deal. 

3. Select a loan and apply: Once you’ve settled on the lender you want to work with, you can begin applying for a loan by submitting an application to the lender and providing them with the personal identifying information (PII) and documents like your ID, Social Security card, proof of address, income information, and more. You can complete this step in person at a bank’s branch if it has physical locations, although many banks have online applications. 

“The lender will review your income, debts, and credit scores. If approved, the lender will deposit the requested funds into your bank account,” says Trevor Yochum, certified financial planner,  CIMA®, and managing partner at Investment Advisor at Incompass Financial Partners.

What can you use a personal loan for? 

Personal loans can be a great way to access cash for some of life’s more expensive milestones or setbacks. A few common uses for personal loans include: 

1. Debt consolidation: Say you have multiple loans with multiple loan payments and interest rates; a personal loan may be a good way to simplify your monthly payment, and it could help you save money each month if you can secure a lower interest rate. 

2. Home renovations and repairs: Home improvements can be a good way to boost your home’s value and in turn increase your home equity—but they can come at a cost. You might consider using a personal loan to finance these projects and ease the burden on your budget

3. Emergencies: If you find yourself in a situation where you have to cover the cost of an emergency—say, an unplanned medical expense—a personal loan can be a quick and easy way to cover those costs. Although, in an ideal world, you should aim to build a hefty emergency fund to cover these expenses and save a personal loan as a last resort. 

4. Vehicle financing: Auto loans may offer better rates when it comes to vehicle financing, but they typically require buyers to make a down payment. If you need a vehicle and aren’t prepared for the upfront costs, a personal loan might make the buying process easier if you can get a loan that doesn’t require any collateral upfront. 

Personal loans are a great tool for accessing cash quickly for a larger expenses may not fit neatly into your budget, like moving expenses, costly medical procedures, and even a wedding. However, you should be wise about how you’re using this money and make sure that it’s going toward an expense that’s worth the repayment term and interest you’ll pay over the life of your loan. 

What should you avoid using a personal loan for?

There are certain gray areas that personal loans don’t cover because of specific lender restrictions. You’ll want to read your lender’s fine print to determine if there are any restrictions or limitations related to your loan and what you can use it for. You’ll also want to consider if it’s a wise move for your personal financial situation. 

“Personal loans are a quick way to access cash; however, I would advise against using a personal loan for discretionary expenses such as vacations as there may be better ways to pay for those,” says Yochum. 

A few instances when a personal loan isn’t an option or may not be your best option: 

1. College expenses: Certain lenders explicitly prohibit using your personal loan to pay for expenses like tuition or room and board. Why? Because the Higher Education Opportunity Act put certain rules and regulations in place for educational loans, and personal loans don’t meet these same standards. You may also be able to secure better terms through an educational loan that often has lower approval standards catered to college students who typically have thinner credit profiles. These loans also come with added benefits if they’re backed by the federal government, like income-based repayment plans and certain forgiveness programs. 

2. Business expenses: Some personal loans can be used to start and fund your business, but this is not the case across all personal loans. 

3. Investing: There are lenders that allow you to use a personal loan for investment purposes, but this isn’t the wisest choice. You could be working against yourself and reduce the overall return on your investment because what you’ll earn in dividends, you’ll lose in interest throughout the terms of your loan. You might be better off putting some money in a savings account or CD, letting it compound over time, and then investing those funds down the line. 

4. Down payment on your home: Conventional and FHA mortgages prohibit the use of personal loans as a source for down payments. Even if you’re able to find a lender that allows it, adding another debt payment on top of your mortgage payment could stretch your budget to the limit. 

The takeaway

If you’re considering a personal loan, having a clear idea in mind of what you’ll use the money for and the costs associated with the loan is key. 

“Lenders may attract customers with a low interest rate; however, there may be additional expenses or the interest rate may change over time,” says Yochum. “The most important consideration is to ensure [that] you have a game plan to pay the loan back before borrowing.”

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