Is Taking Out a Personal Loan a Good Idea? Pros, Cons and Everything in Between…

Blog PersonalLoan@72x

By Donna Freedman

In a perfect world, we’d earn enough to cover all our expenses. But sometimes life happens. We wind up in consumer debt due to medical expenses, car trouble or other issues. Suddenly those ads for personal loans start to look like the perfect answer.

Is it a good idea to get a personal loan? That depends.

A small personal loan might be just what you need to get out of a short-term jam, especially if it was due to bad luck. But a loan could make things worse if you can’t meet the payments, or if you use borrowing as a quick fix instead of addressing bigger financial issues in your life.

This is a complicated subject, so we’ve broken it down for you. Here’s what you need to know about personal loans.

What is a personal loan?

A personal loan is typically short-term, and must be paid off within a few months to a few years (although they can last longer). Most personal loans are unsecured, which means there’s no collateral (personal or financial property) to guarantee the loan in case you stop paying it.

Unsecured loans might be the only kind that many young people can get, if they don’t have any collateral. These loans tend to have higher interest rates, because they’re riskier for the lender.

How much interest you pay and whether you meet the loan’s eligibility criteria will also be affected by:

  • Your credit report. Delinquencies, bankruptcy, accounts sent to collections and other issues on your credit history can affect your chances.
  • Your credit score. A good to excellent FICO score (690 to 850) could lead to a lower interest rate. However, it’s still possible to get a personal loan with a less-than-perfect score, especially with online lenders.

When does a personal loan make sense?

A common reason for personal loans is to pay off credit card debt or other consumer debt, sometimes in the form of a debt consolidation loan.

Maybe you got divorced and had to put your lawyer’s fees on a credit card with a high interest rate. If you can get a personal loan at a lower rate, you’ll save money over the long haul.

Medical bills are another reason to file a personal loan application. Suppose your deductible and copays from a recent illness added up to $2,000. The doctor demands at least $400 a month in repayment, but you just don’t have the money.

A personal loan with a decent interest rate would let you zero out the medical debt, then repay the loan at a lower monthly rate that you can afford.

Or suppose you just graduated and got a job but don’t have a vehicle. A cousin going into the military will sell you his car for $5,000; you’ve got $1,500 and your parents can chip in another $1,000.

In that case, a personal loan for $2,500 would mean you could get to work every day. (And once it’s paid off, you could start making “car payments” to yourself, by setting aside cash each month for future wheels.)

In cases like these, a personal loan could be the right call if it will save you money over the long haul. Do the math first to be sure you’ll save money; don’t forget to factor in any loan fees.

Make absolutely sure you can repay the loan every month in addition to your other bills. After all, with a credit card, you have the option of making a minimum payment during a financially challenging month. But with a loan, you must repay in full no matter what.

Missing a payment, even by a day, could mean a late fee plus a ding on your credit score. Automating the payments can help you avoid this; you might also get a slight rate discount (generally 0.25 percent) if you arrange automatic payment.

When should you NOT get a personal loan?

As with so many other personal finance topics, it comes down to a question of wants vs. needs. You need food; you want lobster. You need to deal with this unpaid credit card debt; you want to go to Hawaii with your besties.

“Do you literally need it to survive? If the answer is ‘no,’ then you shouldn’t be taking out a loan for it,” says certified financial planner Ian Bloom, of Open World Financial Life Planning in Raleigh, NC.

Dream vacations, lavish weddings and such can be wonderful things to have. But they likely aren’t worth the total cost of the loan once you factor in fees and interest. Instead, Bloom suggests holding off and saving up for your dreams.

You could also scale back expectations (such as looking for a cheaper wedding venue) or postpone that vacation with friends until you can pay cash. There might be pushback from others, but keep in mind they’re not the ones taking out the loans, or having their financial futures compromised because of it.

How much does a personal loan cost?

Banks, credit unions and online personal loan lenders advertise APRs from 4.99% to upwards of 20.89%. The better your credit score, the more likely you’ll get a favorable rate.

Subprime personal loan lenders advertise interest rates as low as 5.99% – but they also have rates as high as 35.99%.

Keep an eye on fees, too. It’s common to see an origination fee of 1% to as much as 8% of the loan amount. Some lenders charge application fees as well as origination fees.

Where should you get a personal loan?

If you decide to borrow, it’s essential to shop around. A good place to start is a credit union, since they tend to have lower interest rates. As of December 2019, the average interest rate on a 36-month unsecured personal loan was 9.36% at credit unions and 10.18% at banks.

Note: Some federal credit unions offer a special product called a payday alternative loan. These are good for up to $2,000, with repayment plans of one to 12 months.

Often, a good credit score is not required for a payday alternative loan; instead, the focus is whether the borrower can repay the loan on time.

Some other options:

1 - Banks

Already have a banking relationship? Ask about personal loans.

“They know you and they want to keep your business,” says Becky House, education director for the nonprofit American Financial Solutions in Seattle.

Be sure to compare the bank’s terms and fees with other loan sources, though. Note: Some banks won’t offer unsecured loans unless you’ve got a strong credit score.

2 - Online lenders

These tend to be easier to get, even if you have a credit score of 550 or less. However, the rates can be very high. You might want to improve your credit so you can qualify for better rates in future.

3 - Subprime personal loan lenders

“Subprime” means people whose credit isn’t good. That could be because you’re just starting out, because you’ve made poor financial choices in the past, or because you’ve had issues such as needing to rebuild credit after divorce. The interest rates also tend to be very high.

Peer-to-peer lending

These online platforms let individual investors fund personal loans. The interest rates can be high if you don’t have a good credit history and credit score.

Advantages of a personal loan

Pro 1: It can be fairly easy to get.

However, you should be wary of borrowing at a high interest rate, or of taking out a loan as an easy fix instead of looking for other solutions.

Pro 2: It can be fast.

Some online personal loan lenders can have you the money within a day of approval. (Again, be cautious about making snap decisions.)

Pro 3: A personal loan has a set amount to pay each month and a specific end date.

With a credit card, it can be tempting to just pay the minimum some months, which drags out repayment and results in more interest paid overall.

Pro 4: Done right, a personal loan could help your credit score in two ways:

  • It improves the “credit mix.” Having both installment credit (the loan) and revolving credit (your credit cards) shows that you can handle both types responsibly.
  • If you use the loan to pay off consumer debt, your credit utilization ratio (how much you’re using of all available credit) will drop. Credit utilization counts for 30% of a FICO score.

Drawbacks of a personal loan

Con 1: Interest rates can be very high if you have no credit or less-than-stellar credit.

Con 2: If you get sick or lose your job and miss a payment, it hurts your credit score.

Con 3: If you can’t make the payments at all and default on the loan, it might be sold to a debt collection agency and you could be sued for the balance.

Then there’s the “opportunity cost” of a personal loan. Every dollar you pay in interest is a dollar that can’t work for you in some other way, such as paying off student loans or saving for retirement.

Some red flags to watch out for

Bloom suggests avoiding loan sources that advertise, “Bad credit? No credit? No problem!” Such places are “a huge pain to deal with” and generally have much higher interest rates.

The CFP also says not to get advice from a website with “15 different pop-up ads for payday loans – that’s probably not a good source of information.”

A loan company that requires a fee before you can get the money “is most likely a scam,” according to House. She also recommends avoiding longer-term loans because you’ll wind up paying more interest for the privilege of lower monthly payments.

Terms can be confusing, so read carefully. One of House’s clients found a loan with a surprisingly low payment, which would work well with his budget. When he read the fine print, however, he realized the payment was to be made twice a month.

“He was lucky he realized it before he accepted the loan,” House says.

What about other options?

Rather than borrow to consolidate their debts, some people opt for debt management: sending money to a credit counseling agency that pays your creditors, and sometimes negotiates lower interest rates and fees.

Some sketchy companies are operating out there, however, so it’s important to do your homework. (Learn what you need to know by reading “What is Debt Management?”)

Family or friends may be willing to lend you money, possibly interest-free. Before you ask, draw up an agreement stating why you need the cash and how much you’d pay back each month (or each week).

Note: Owing someone money can make the relationship super-awkward. Only you can say whether it’s worth it.

Moving your consumer credit card debt to a 0% balance transfer card could also be the answer. During the 0% interest introductory period, all the money you’d been paying as interest would go toward zeroing out the debt.

However, this option works only if you have the discipline to pay it off on time (generally 12 to 21 months). After that, the interest rate jumps up – maybe way up – and you’re back to making payments on a high-interest card.

Do you really need a personal loan?

Before you decide to borrow, ask yourself: Is there any way I could fix this issue without a loan?

Start by tracking your spending: on paper, with a spreadsheet, or with free or paid tools like Mint or MaxiFi.

“When they see it in black and white, it’s really eye-opening: ‘I spent how much going out to dinner?’,” says certified financial planner Tara Unverzagt, of South Bay Financial Partners in Torrance, Calif.

Next, plug the money leaks by creating a workable household budget, one that includes saving for the future while having a little fun in the present.

Many people swear by the “50/30/20” budget; the U.S. Consumer Financial Protection Bureau offers a free worksheet for this budgeting plan.

(Hate the idea of a budget? Think of it as a “spending plan” – a way to get the most out of your money, both now and in the future.)

You could also request a fresh set of eyes on your finances. The nonprofit National Foundation for Credit Counseling can set you up with a counselor who can look over your money issues, and possibly work with creditors on your behalf. The help is on a sliding-scale basis.

Another option is the Foundation for Financial Planning, whose members offer pro bono money help throughout the United States. To look for a chapter near you, visit the FPA’s website.

Suppose that creating a budget you can live with means an extra $250 a month. You might get even more with strategies like:

  • Taking on a few extra hours at work if possible, or getting a side hustle such as delivering pizza or driving for a rideshare company.
  • Bringing your lunch to work at least twice a week and cooking at home at least three nights a week.
  • Going out with friends once or twice a month instead of every Saturday.
  • Temporarily cutting out shopping, sporting events, concerts and movies in favor of cheaper or even free ways to have fun.

Some of House’s clients have used these tactics successfully. The temporary sacrifices aren’t always easy or comfortable, but they pay off (literally!).

“They come out with less debt, and better credit,” she says.

Even if you still have to take out a personal loan, reducing the debt upfront means you’ll need to borrow less. Think about it: Wouldn’t paying back $1,000 (especially through one of those payday alternative loans from the credit union) be better than needing to pay back $2,000?

Avoiding future loans

It isn’t enough to pay off debt or fix a temporary money problem with a personal loan. You need to address the reasons behind the emergency.

They could be unavoidable, such as illness or job loss. But sometimes they’re completely avoidable: a shopping addiction, frequent electronics upgrades, going out with friends three or four times a week.

Sometimes the issues are less obvious. Maybe you’re overspending in small ways or in larger ones, such as getting an apartment on your own instead of sharing a place, or leasing a new car every two years.

As a result, the credit card balance grows faster than you can pay it off.

In this case, taking out a personal loan is just kicking the can down the road. Reducing credit card debt right now does reduce the amount of interest you’ll pay. But if you don’t address your spending habits, the problem will likely return.

Debt and borrowing become a never-ending cycle that “makes it harder to make progress in other areas of your financial life,” Bloom says. The loan interest reduces how much you can save for a home, retirement or even a vacation.

“Every debt you run up has a cascading effect on the rest of your finances – present and future,” Bloom says.

The bottom line

A personal loan could be the best way to get out from under short-term debt. But it’s not a step you should take lightly. Do the math, weigh the pros and cons, and investigate other options.

If you decide a loan is the right thing to do, shop around for the best possible deal. Then take charge of your finances to prevent the need for more borrowing, in order to create a secure financial future.

About the author

Longtime personal finance writer Donna Freedman lives and writes in Anchorage, Alaska.

Written on March 24, 2020

Self is a venture-backed startup that helps people build credit and savings.
Comments? Questions? Send us a note at hello@self.inc.

Disclaimer: Self is not providing financial advice. The content presented does not reflect the view of the Issuing Banks and is presented for general education and informational purposes only. Please consult with a qualified professional for financial advice.

Ready to join Self?