People who approach banks to get a loan usually do so to solve a big problem in their life. Since these requests are very typical, bank clients (all of us) are offered loan terms that are more or less standardized. This applies to mortgages, auto loans, and business or student loans.
However, banks also offer personal loans for requests which don’t fall into these typical categories.
What is a personal loan?
A personal loan is characterized by:
- a relatively short run: between one and five years,
- a loan amount of less than $50,000,
- availability on fairly short notice,
- and the fact it’s paid back in (usually) monthly installments.
Personal loans are used to consolidate previously accumulated debt, for large purchases, or to cover unexpected expenses. Obviously, you can use these loans to patch up everything else in between.
The loan is a type of credit
A personal loan can also be offered by lenders and credit unions, but ultimately (and as banks would put it), these loans are a “credit product”—meaning interest is to be repaid on top of the borrowed sum.
No collateral is required to get a personal loan as opposed to a mortgage (or auto loan) where you can lose a property (or car) if you miss payments. That’s the main advantage of this type of unsecured loan—the sum is not big enough to cause a lot of trouble.
Common uses for personal loans
Personal loans are great for expenses that you can’t afford to pay upfront, provided the interest rate is acceptable. If you have a specific purpose for this money in mind, you are probably wondering: “Can I use a personal loan for anything I want?” The short answer is yes. You can do whatever you want with the money as long as you are able to handle the monthly payments.
But, just because you can, it doesn’t mean that a personal loan is always a good idea. It’s important to understand their advantages and disadvantages before you actually take a loan. Let’s check out the typical uses of personal loans along with a few examples where this approach doesn’t work.
A personal loan may allow you to crunch all of the outstanding amounts into one payment. So, instead of making separate payments—one as a balance on your credit card, separate payment for an accumulated debt (e.g. utilities), and another payment if you already have a different loan—a personal loan can streamline debt repayment.
Credit card debt
Loans are installment credit (paid each month), while credit cards are revolving credit (available as needed), so interest rates for revolving credit are generally higher because they offer greater flexibility. You can use a personal loan to pay all of the debt with low interest. Of course, this will work as long as you don’t create new debt on your credit card.
Taking a new loan is also recommended when interest rates drop. The personal loan with favorable terms (low interest) will allow you to pay less if you arrange repayment of an old loan with disadvantageous terms (high interest). Please check the origination fees for the personal loan before doing this because if they are too high, then there is no point in taking a new loan.
Debt consolidation via a personal loan provides a sense of purpose because there is a set debt repayment date.
Collection agency debt
Using a personal loan to get rid of the badgering of a collection agency is a good way of utilizing credit. Aside from providing relief from the pressure, the loan itself will also immediately improve your credit score.
Settling other debts
The key to this issue is to get a personal loan with terms that are better than the debt you are up against. In some instances, this might even apply to your tax debt, or for repayment of your student loan. On the flip side, if you use a personal loan to pay for college debt, you can lose privileges like partial student loan forgiveness.
Another instance of debt repayment that can cost you a lot, and not in interest rates or processing fees, is borrowing from friends or family members. The moment you get a loan from someone that is close to you – the relationship is at risk. Personal loans can be used to patch up these kinds of issues and to put matters back on good terms. Or you can be on the other side and take a personal loan to help someone out when they are in over their head. Renegotiating debt repayment with a personal friend can be tricky, to say the least, so the risks are different in these situations.
This is one of the most typical examples of using personal loans. Appliances like washing machines, elaborate gaming consoles, and home cinemas are usually beyond the regular monthly budget in a given household. Especially if you are facing an unexpected malfunction of an appliance and you need to replace it. There are two options – people can either save money for months on end to get these appliances or they can go into debt and get them right away. The advantage of taking a personal loan for such big purchases lies in the fact that you will be able to use the appliance immediately. The downside? You have to pay interest on the loan.
Maintenance costs on any building, be it residential or commercial, are always a nag. Some home renovation projects, like when you’re knocking old walls down to remodel them, can be planned in advance. But then there are always unforeseen situations that might require you to spend funds you don’t have, and urgently.
If the project concerns repairs, it’s best to check whether insurance covers the costs. If that’s not the case, banks offer home equity line of credit (HELOC), however, with that type of loan, you are practically placing the building as collateral. Renovation costs are high, but they hardly ever come close to the value of a property. A personal loan is a far more suitable alternative to home equity loans because it doesn’t put the whole house at risk if the debtor fails to meet the financial obligations.
In addition to this, it’s important to consider whether this home renovation project is a necessity or a desire. In other words, if you can’t afford it and it’s not necessary, you can drop the project.
Obviously, some expenses can’t be foreseen and people need to act quickly under strenuous circumstances. Even if you have a savings or retirement account, the money in those funds might not be available on short notice.
Ideally, you want to use health insurance to cover your medical bills. However, personal loans can be a good way to settle unexpected medical expenses because you get the money fairly quickly, and even if you do have health insurance, it might not cover everything. Bills for urgent medical treatments and resultant aftercare are typical examples, although some folks also use loans for expensive procedures like cosmetic surgery or fertilization programs.
Before going for a personal loan, check if the health care provider offers a payment option that doesn’t involve interest. Some medical credit cards offer interest-free payments if you settle the debt within a preset time frame (24 months or so).
Untimely death hits families without warning. Not only do close members have to deal with bereavement, but the bills quickly add up and can go into the thousands. If the deceased did not have life insurance or adequately prepare for funeral expenses, a personal loan can fix the situation.
Events like moving from one place to another should be planned and budgeted for well in advance. But life happens, and this might not always be the case in practice, such as in the cases of divorce or a sudden job offer that requires you to move.
If you need to relocate long distance within a fairly short time frame, there are many things to consider (furniture, vehicle transfer, transfer of other belongings) and costs go up quickly. Taking a personal loan for moving is not ideal, but some people go for it if they don’t want to touch the rest of their credit.
The logistics of separation because of divorce can create unavoidable costs. A personal loan can help ease the transition, particularly if it comes out of the blue, and paying the interest for borrowed money is worth it in the long run as it can help you plan your new life more easily in this difficult situation.
Better option to a payday loan
The catch with payday loans is simple: you can obtain them without a credit score check, but repayment has to be done on time. If the lender misses so much as one single payment, the interest and service fees go through the roof very quickly.
While the interest rates of conventional credits depend on the borrowers’ credit score and are not higher than 20-30% (personal loans included), a payday loan accumulates 400% interest within weeks. These are usurious rates and even though it might take some time to get a personal loan, it’s always better to do that than go for what loan sharking offers.
Buying a vehicle
Now, there is such a thing as an auto loan. They are credit products specifically created for getting cars, but unfortunately, they predominantly apply to new vehicles. And the car itself serves as collateral, so if you miss payments, eventually, your vehicle will be repossessed.
But what if you want to get a loan for a used car? Personal loans are great in this regard because the car will remain yours. You are not reaching into a savings account to buy it and there is no down payment for personal loans (while for auto loans, this is a requirement).
Naturally, this applies to all sorts of vehicles, not just cars. Sometimes an upgrade of a recreational vehicle (RV, boat, or 4×4) or the truck you use as a workhorse can be costly – a personal loan will solve the financial aspect of the issue.
Banks and lending institutions don’t have specific offers for celebrating important life events, so personal loans can provide much-needed financial support.
The average cost of wedding celebrations in the U.S is over $30,000. The bill quickly adds up: the venue, catering, photography, a music band, and especially the engagement rings; you probably understand that the figure above might be a conservative estimate. Some might argue that an elaborate wedding is a luxury, and if you need to get into debt to arrange it, maybe you should consider more frugal options.
If paying interest to organize a wedding is not an issue for you, then a personal loan is fit for this purpose.
Speaking of weddings, what about a honeymoon in an exotic setting? Well, if you need to take a personal loan and later pay interest to make it happen, then you should probably pass. But, not all travels are the same. Sometimes travels can be very unique experiences, for religious, professional, or personal reasons.
If you feel that a particular trip will be of great significance to your life, then taking a personal loan might be the only option to finally make the leap and do it. Spending years to save up for a trip might come back to bite you, and by the time you can afford such travel, the trip itself might no longer be a priority. Or even worse—it’s no longer relevant. For example, saving for a sailing vacation and being able to afford it in your 60’s when your body will have a hard time coping with harsh sea conditions.
On the other hand, taking a loan to arrange a getaway just because you experience burnout at work might not be the best possible use of such funds. If you can’t afford a trip, find another way to restore your mental balance.
Straight up: taking a personal loan for business expenses is not a good idea. There are credits specifically designed for entrepreneurs across all industries. If you take a business loan and the company (or project) fails, you declare bankruptcy and that’s it. But, taking a personal loan for business will reflect on your credit score, and if things go south… you don’t want that stain on your credit report.
A look at the numbers
If you are new to the world of personal finance, you probably don’t know that credit products aren’t identical all across the board (not in the dollar-for-dollar sense of the word). The monthly payment on two separate offers for a loan might appear almost the same, but one of those offers is definitely more favorable than the other. How to tell the difference?
Personal loans are defined by three crucial terms: the repayment term, the interest rate, and the amount of each monthly payment.
A repayment term specifies the exact number of months (12–60) to repay the loan. The interest rate is the profit your lender will take from you for providing the loan. Lastly, monthly payments are determined upfront, so that both parties are aware of the loan repayment schedule.
Compare aprs for personal loans
Despite all that, the annual percentage rate (APR) is the most important piece of information for comparing competing offers for a personal loan. This is a term that includes origination fees into the equation—a cost that is excluded when you simply look at interest rates and monthly payments.
The APR is the total sum (borrowed amount + interest + fees) adjusted to interest on a yearly basis and expressed in percentage points. Loans with the lowest APR within a given loan term are the best offer. Borrowers with high credit scores (FICO 690 and up) get a personal loan at APR below 20%. Lenders usually offer personal loans with an APR of up to 30% to subprime borrowers.
The case against personal loans (or when not to take personal loan)
In most of the instances described above, personal loans are put on the spot and compared to other credit products. Whether you are considering auto loans, HELOCs, payday loans, or any other alternative to taking a personal loan, then you obviously need to weigh the options.
The following information can help you decide which option is better.
- Credit that includes a grace period (sometimes up to 18 months or more) allows the debtor to cut on the interest. Once this period ends, you will start paying according to the interest rate, but the total amount paid will be lower.
- A loan without an origination fee cuts down on a lot of the costs. This one is like Bigfoot—many have heard about it, but hardly anyone has seen it. Jokes aside, the offer without fees (or with lower fees) is better. If there is no fee, the APR is actually the same as the interest rate.
- A loan with a lower APR is better. We already explained why.
- A loan that is specifically designed for a certain purpose will generally be better. For example, car loans vs personal loans, or medical cards vs personal loans. The purpose-made loan can have better terms like a lower interest rate or a longer repayment period, so study those very carefully before making a decision.
- Don’t take a personal loan if you are not able to meet the monthly payment minimum over time. It will create more problems instead of solving them. Even if you are expecting a certain change in your purchasing power, things change in both directions so make conservative estimates.
- Don’t take out a loan if you have issues with budgeting. Personal loans work only if you stop detrimental habits that got you into debt in the first place. Creating a payment plan can help, but consolidating credit card debt with a loan is a bad idea if you intend to max out the credit card shortly after.
Personal loans could solve a lot of issues and empower you to make purchases that are above your monthly purchasing power. They are versatile credit products and you can get them based on your credit report as an unsecured loan (i.e. without putting up collateral).
Compare the terms of competing loan offers (read the small print) and look for the one with the best terms out there.