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Personal loans are a great way to fund large expenses like medical bills or home renovations, or to consolidate your debt from other lenders. While they can be an attractive alternative to other products with higher interest rates, personal loans do have some drawbacks. Like any other credit product, personal loans can only serve you well if you are able to use them responsibly and make your monthly payments on time.
What is a personal loan?
Personal loans are a form of unsecured debt that don’t require collateral, like a home or vehicle, to guarantee repayment. However, that means they can be difficult to qualify for without good credit or a decent income.
“The interest rates also tend to be substantially higher than on secured forms of debt, such as a home mortgage or home equity line of credit,” said Chad Rixse, director of financial planning and wealth CFO at Forefront Wealth Partners in Dripping Springs, Texas. “On the plus side, they're typically fixed interest rates and still lower than credit cards, providing a lower-cost alternative and a quicker path to becoming debt-free — and you don't have to be a homeowner to acquire one.”
Loan terms are typically for 12 to 60 months, or longer. Because there are no restrictions around their use, borrowers can apply loan funds toward a wide range of projects.
What can a personal loan be used for?
You can use a personal loan for anything you can imagine, from paying off wedding costs and medical expenses to financing the costs of renovating your home or consolidating debt.
However, you should only use a loan if you need the money, since you’ll be paying interest charges on the funds. Make sure to only borrow the amount you absolutely need and what you can afford to repay.
Top reasons to get a personal loan
As stated above, personal loans can be used for various purposes, including consolidating debt and renovating your home. Below, we've listed some of the top reasons to get a personal loan.
Consolidate or pay off debt
If you’re juggling multiple forms of debt, personal loans can be a good tool to help you simplify your financial life while also lowering your monthly payments.
“Because personal loans can offer a lower interest (rate) than many credit cards and have a strict payment schedule, someone committed to getting out of credit card debt can find a personal loan extremely useful,” said Joseph Toms, the San Mateo, Calif.-based president of FreedomPlus.
Finance emergency expenses
Whether you need a tooth pulled or your car just broke down, if you don't have enough funds to cover the expense, a personal loan can give you the quick boost of funds you need in a pinch.
Potentially improve your credit score
Showing that you are able to juggle different kinds of debt and pay them off on time regularly can have a positive effect on your credit score, which gives you a better chance of being approved for a loan. However, there are other ways to demonstrate financial responsibility that don’t involve getting deeper into debt, so this should not be your only reason for taking out a personal loan.
Choose from unsecured and secured loan options
One of the perks of a personal loan is that they are often unsecured. This means you don’t have to put up an asset as collateral which you risk losing if you can’t pay off your debt. However, institutions often offer lower rates to borrowers willing to put up collateral in a secured loan, as this lowers their risk in lending money to you.
Personal loan drawbacks
There are some drawbacks to personal loans. For example, they may come with origination fees of up to 5% of the loan amount. There may also be additional fees for late or unsuccessful payments, personal check processing, or even for paying off your loan early, Toms said.
Being able to take out a personal loan may also not be resolving the underlying issue of why you need it in the first place, said debt resolution attorney Leslie Tayne, the New York-based author of “Life & Debt.” “Many believe a personal loan will solve the issue of paying off other debts, but that is only robbing Peter to pay Paul. The reality is that by taking the loan, you could be perpetuating issues of limited cash flow and inability to pay debts.”
Personal loan alternatives
Depending on your unique situation, a personal loan may not be the way to fund an expense. For example, using a credit card can help you rack up air miles or offer you an extended warranty on a major purchase.
When determining the best personal loan alternative for you, you should evaluate why you need the funds, the amount you need, and your budget to pay it off.
“In addition, you need to know your credit score, since that could not only impact your ability to get the loan but the interest rate you pay, and ultimately the amount per month you’ll need to budget for,” Tayne said. “Know all these variables ahead of time, and don’t rely on promotional offers.”
Credit cards are generally better-suited for smaller expenses, but just like personal loans, they have the potential to carry high interest rates based on your credit score, Tayne said.
A credit card allows you to borrow against a credit line over an indefinite period of time, rather than giving you one lump sum and a fixed schedule to pay it off like a personal loan. It may also come with an annual fee.
Home equity loan
If you have enough equity in your home left over after your mortgage, you could qualify for a home equity loan. This is a type of secured loan that uses your home as collateral in case you are unable to pay off your debt. While the risk of losing your home may not be worth it to some borrowers, a home equity loan does come with considerable advantages. These include being able to borrow at a much lower fixed rate of interest over a longer period of time, having access to a lump sum of cash and being able to deduct your interest off your income taxes.
Personal line of credit
A personal line of credit is an unsecured, revolving form of credit product similar to a credit card, with varying interest rates and payments that fluctuate accordingly from month to month. These funds are typically accessible via bank transfers or line-of-credit checks, and, as a borrower, you’ll be given a credit limit for the term of the loan.