Pros and Cons of Personal Loans

Personal loans can be a quick way to borrow money from a bank, credit union or other financial institution. But like all debt, they have both benefits and drawbacks to consider. So, before things “get personal” by way of a personal loan, check out the pros and cons and how to choose a loan that works for you.

Pros of Getting a Personal Loan

Personal loans may be the right choice when you’re in a tight spot and need some money to tide you over. They can be used for almost any reason and typically come with lower interest rates and better terms than high-interest credit cards. Take a look at several other benefits of personal loans.

Competitive Rates

Personal loan interest rates are generally lower than credit card rates. In August 2022, the average credit card interest rate on accounts with balances that assessed interest was 18.43%, according to the Federal Reserve. Conversely, the average interest rate for a 24-month personal loan was 10.16%. You’ll likely need good to excellent credit to get the best annual percentage rate (APR) on your personal loan.

If you took out a 24-month personal loan for $10,000 with a 10.16% APR, you would pay $1,092.51 in interest. Paying that same amount in 24 months on a credit card using the average interest rate above means you’d pay $2,031.71 in interest—nearly 86% more in interest than with a personal loan.

Manageable Terms

Personal loans are paid out in one lump sum, with flexible terms that allow you to choose your repayment period based on the monthly payment you can afford. Generally, repayment terms range from two to five years, though some lenders provide extended repayment periods. If you want to pay off your loan quickly to save on interest and can afford a higher monthly payment, opt for a shorter-term loan. If you prefer to spread out your payments longer to keep your monthly payments lower, understand that you will pay more in interest over the term of your loan.

Stability

Most personal loans come with fixed rates that remain the same over the life of your loan. That means you’re left with one fixed monthly payment for a set period of time. That stability can make it easier to budget, save for the future and pay off your loan without worrying about rate increases. But, to ensure your budget remains stable, make sure you can cover your new monthly payments along with payments on your other debts and essential expenses before taking out a personal loan.

Flexible Borrowing Limits

Although borrowing limits vary by lender, personal loans limits can range from a few thousand dollars to as much as $100,000. The higher the limit, the more challenging it can be to qualify and repay. Lenders will consider your income, debt-to-income ratio (DTI) and more when determining a loan amount. And, while a large loan might open up more options for its use, it can also mean more debt, so it’s important to only borrow what you need to meet your needs.

Helps Build Credit

Managing a personal loan responsibly by making all your payments on time and in full can help you build credit. On-time payments reflect a positive payment history, which is the most important factor in your FICO Score, the credit score used by 90% of top lenders. Additionally, if you don’t have any other installment loans, such as a car loan or mortgage, a personal loan will improve your credit mix, which accounts for 10% of your score.

Cons of Getting a Personal Loan

While securing a personal loan does come with many benefits, there are several key drawbacks as well.

Additional Debt

You can use a personal loan for almost any reason, but it’s important to have a plan to pay it back. Before you commit to a personal loan—either big or small—think about why you’re borrowing the money and what it will be used for. Paying for a large, unexpected medical emergency or consolidating high-interest credit card debt can be practical reasons to get a personal loan. But think carefully before paying for optional events like a vacation or a wedding, financing a new vehicle or paying college tuition. Instead, making a plan and putting money in a savings account rather than using a personal loan and paying interest for an extended time can make more sense.

Fees and Penalties

In addition to the interest rate charged on your personal loan, some lenders also charge fees like application and origination fees to process your loan. In fact, origination fees alone can range from 2% to 5% of the loan amount. You might also be charged a penalty for making a late payment or for insufficient funds if your payment is automatically withdrawn from your bank account. Your lender may also charge a prepayment penalty if you pay off your loan before the end of the term, although many personal loan lenders no longer charge this fee.

Payback Commitment

As with any debt, when you take out a personal loan, you enter into a short- or long-term commitment with your lender. Miss payments or default on your loan and you damage your credit and risk the opportunity to qualify for credit in the future. Getting a personal loan can also increase your DTI, which is one factor lenders look at when determining your eligibility. If you don’t have the income or you don’t have the money in your budget to repay your loan, it’s probably not the best option.

Credit Impact

While making all your personal loan payments on time every month can help your credit, missing payments or defaulting on your loan can damage your credit. When you apply, your lender will likely do a hard inquiry to check your credit, which can also impact your scores temporarily. Setting up autopay and reorganizing your budget to include your new loan will reduce your risk of missing a payment and hurting your credit.

Higher Interest Rates

Although personal loans typically have competitive APRs based on your creditworthiness, they can have higher interest rates than secured loans, like home equity loans and home equity lines of credit (HELOCs). That’s because most personal loans are unsecured, meaning there is no collateral (like your home) for a lender to seize if you fail to pay your loan in full. Lenders make up this risk by charging you more to borrow money. Personal loan interest rates can vary quite a bit, from less than 6% up to 36%, and sometimes higher.

How to Choose a Personal Loan

Many banks, credit unions and many online lenders offer personal loans. The best loans feature low interest rates, low fees and no penalties for eligible borrowers. Consider these factors when choosing a personal loan.

  • Check rates based on your credit. The higher your credit score, the better your chance of earning the best rates and terms on your personal loan. You’ll likely also have more lenders to choose from. If your credit needs work, do what you can now to improve your credit by paying down credit card balances, avoiding taking on any new credit, paying off any past-due accounts and signing up for Experian Boost, which lets you add on-time payments for utilities, streaming services, cellphone and rent payments to your credit report to help boost your credit score.
  • Decide how much you need. While it’s best to borrow enough to cover the reason for the personal loan, borrowing more than you need is rarely a good idea. Review your budget to be sure you can afford to pay back the loan. Keep in mind that some lenders charge origination fees, which will typically be deducted from your loan amount. Prequalifying will give you an idea of how much you’ll qualify for and what rate you’ll pay on your personal loan. You can also use Experian’s personal loan calculator to compare your options and estimate your monthly payments to find the best loan for you.
  • Compare rates and lenders. The interest you pay on your loan is typically expressed as an APR, which includes fees and other costs of the loan. When comparing lenders, look at rates and terms and don’t settle for the first offer you receive. Generally, lenders allow you to get prequalified with a soft credit check, which won’t impact your credit score but will give you an understanding of the rates available to you.
  • Consider all your options. If you find you can’t qualify for the best rates on your personal loan, consider adding a cosigner to your loan. If your lender does not allow cosigners or you can’t find one, you may consider getting a secured personal loan instead of an unsecured one. But keep in mind that secured loans require collateral. That means if you default on your loan, you risk losing your collateral. Also consider alternatives such as putting off the expense until you can save up the funds (if it’s not an emergency), borrowing from friends or family or using a credit card with a 0% introductory APR.

The Bottom Line

Personal loans can be used for many reasons, but there are times when a personal loan isn’t the best option. That’s why it’s so important to consider both the pros and cons first. If you have the money in your budget to make the payments on time every month, then a personal loan can be a good choice to pay for an unexpected emergency or cover a large purchase. On the other hand, if your income is low, your credit needs work or you don’t have the budget to ensure the loan is paid back on time, a personal loan could put you in a difficult financial position.

When choosing a personal loan, check out Experian CreditMatch™. Create a free account, and you can then submit a personal loan prequalification request without it affecting your credit. You’ll see loan offers from multiple partner lenders that remain valid for 30 days, so you have plenty of time to compare them and find the right option for you.

The post Pros and Cons of Personal Loans appeared first on Experian’s Official Credit Advice Blog.

https://www.experian.com/blogs/ask-experian/pros-cons-personal-loans/

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