You’re probably aware of personal loans, which you can get from a bank or other financial institution. They traditionally come unsecured, meaning you don’t need to back the loan with collateral to get the funds. What makes them different from other loans, such as a mortgage or a car loan, is that you can use the proceeds from the loan for variety of purposes.
Personal loans are still a relatively uncommon type of financing. Only 1 percent of American families applied for personal or family loans in 2017, and personal loans comprise 1.5 percent of outstanding consumer debt, according to data from LendingTree, which owns Student Loan Hero. Many people are more familiar with applying for a car loan or getting a new credit card.
Personal loans are gaining in popularity, however, for many reasons. They may even be right for you. Here’s a look at the various benefits of a personal loan.
- Build or support your credit score
- Pay for planned expenses with a lower interest rate
- Refinance your high interest debt with a lower interest personal loan
- Consolidate multiple debts
- Know when you will pay off your loan
- Borrow money without risking your assets
- When you’re just going deeper into debt
- If you can get a lower interest rate with another type of loan
- When the bank might not lend to you at a favorable rate
6 ways you may benefit from a personal loan
1. Build or support your credit score
Ten percent of your credit score is based on your “credit mix,” or the different types of credit you have, such as credit cards, installment loans, finance company accounts, and mortgage loans. You can only raise your score so far, for example, by using just credit cards — no matter how faithfully you pay them and keep your balances low. By adding another type of credit, you may improve your credit mix and potentially raise your score.
Be aware that taking out a personal loan may cause your credit score to drop a few points in the beginning. Any time you apply for a loan or credit, the “recent inquiry” on your credit history may cause a small, temporary ding to your score. However, unless you are on the edge of a credit score category and you need to have your score at its best right this minute, this is generally nothing to worry about.
2. Pay for planned expenses with a lower interest rate
Many credit cards carry relatively high interest rates, especially after any low- or no-interest introductory ends — that can cost you a lot of money in the long run.
If you need money for some purpose — like repairing your car, buying new tires, paying for a wedding or taking a trip — try to find a source of money with the lowest rate possible. Even a small savings in your interest rate can save you a substantial amount in interest expense over the life of your loan.
Take a look at how different interest rates can affect the total amount you pay on a $5,000 balance:
|Loan Balance||Interest Rate||Term in Years||Monthly Payment||Total Interest Expense||Total Balance Paid|
If you have a good credit score, you may qualify for a competitive interest rate on a personal loan. You can use our personal loan calculator to see what your payments and interest expense could be on a personal loan. Be aware that if your credit score is lower, you may not qualify for a low interest personal loan.
3. Refinance your high interest debt with a lower interest personal loan
If you have high interest debt (a car loan you got before you improved your credit score, or a high interest credit card balance, for example), consider paying off that high interest debt as quickly as you possibly can. If you can’t pay with cash, you may be able to take out a personal loan at a lower rate to pay off your high interest debt.
With less money going to interest expense every month, you’ll make much faster progress paying off your balance.
4. Consolidate multiple debts
What if you’re spread thin with too many debts — several credit cards and a couple of medical bills, for example? Trying to pay the minimum amounts on more than a few debts can be frustrating, and it’s easy to miss one and rack up even more in interest expense and penalties.
Managing debt is the most common reason people take out personal loans. By taking out one personal loan to pay off several debts, you’ve consolidated your bill paying nightmare into one payment per month. You know how much it’ll be, and you don’t have to decide which bill to pay. Your minimum payment on one consolidated debt is likely to be less than your total minimum payments on a raft of smaller debts, too.
5. Know when you will pay off your loan
If you’ve been trying to pay off a credit card or similar debt, and your balance doesn’t seem to go down — or it actually goes up — you may do better with the structured loan payment plan a personal loan can offer. With a fixed rate and loan term, your monthly payments will be predictable compared to the payments on a variable rate debt.
If you’re considering refinancing or consolidating debt, you can see how a new rate and term will affect your overall costs with this calculator. You can also explore how a shorter or longer term will affect your monthly payments and overall costs of borrowing.
6. Borrow money without risking your assets
Not all personal loans are unsecured, but many are. You may prefer to take out a loan that is not attached to your house, car, or other assets. In addition, using your house as collateral is less attractive under the new tax law — starting in 2018, you can no longer deduct interest expenses on a HELOC as home mortgage expense unless you used the proceeds to buy, build, or substantially improve your home.
Remember, however, that just because a loan is not secured by your house, car, or bank account doesn’t mean the consequences are less dire in the long term if you can’t pay back the loan. Financial institutions can still take all legal measures to collect from you, such as reporting late or missed payments to the credit bureaus and eventually getting a judgment and garnishing wages or seizing assets.
3 times a personal loan may be a bad idea
1. When you’re just going deeper into debt
Not all debt is bad. You can use debt wisely to pay for things you need, to buy assets that last and have long-term value, or as part of a strategy to help you work your way out of debt.
However, some people fall into the trap of trying to solve every money problem by borrowing more. Eventually that gets them into trouble. No debt is good if there’s too much of it, or if your total financial picture is looking worse every single year.
2. If you can get a lower interest rate with another type of loan
If you have good credit, you should be able to get a decent interest rate on a personal loan. However, sometimes another type of loan, like a home equity loan, may have an even lower rate.
Another low-interest rate option may be a credit card with a no- or low-interest introductory rate. These cards work especially well if they motivate you to pay off the balance before the introductory rate ends. Otherwise, if you still owe a substantial amount when the interest rate goes up, you could be right back where you started — spending too much of your money every month just trying to keep up with high interest expenses.
Read the fine print carefully before you take a cash advance or do a balance transfer on a no- or low-interest loan. Most credit card companies charge a transfer or cash advance fee, typically 3%. Try to find a card that doesn’t charge the extra fee, or make sure the total amount you pay on the loan is still worth it to you.
3. When the bank might not lend to you at a favorable rate
To get a personal loan, you need to have a good credit score, generally at least 640. You must also show the bank that you have the means to pay back the loan: for example, a job or other reliable source of income.
More Americans are using personal loans than ever, and the total amount Americans owe on personal loans as of mid-2018 is more than twice what is was only five years ago, in 2012. If you are clear on why you need a loan and what you expect to gain by getting one, and you shop carefully, getting a personal loan could turn out to be a good long-term financial move for you.