Deciding whether to take out a personal loan is a “personal” decision, but it’s also one that’s rife with risk. If you borrow money you cannot pay back, you can end up with all sorts of consequences that make your life more difficult. This could include ruined credit, additional fees and interest charges, and even bankruptcy.
But, that doesn’t mean personal loans are a bad deal all the time. Really, any loan can be a valuable financial tool if used wisely and responsibly — and with a plan in mind.
Still, it’s wise to consider when a personal loan would benefit you, when you should avoid borrowing money, and when a different financial product may just be a better deal.
When You Should Get a Personal Loan
Before you pull the trigger on a personal loan, you should make sure you understand how a loan could benefit you or hurt you. Here are some signs this financial product may be perfect for your needs:
You want to borrow money with a fixed interest rate and fixed monthly payment.
One of the biggest benefits of personal loans is the fact they offer a fixed repayment schedule and a fixed interest rate. This means you’ll be able to agree to a set monthly payment ahead of time, and you’ll never be surprised by a larger-than-usual bill.
If you need to borrow money but don’t want any surprises along the way, a personal loan may be exactly what you need.
You need to borrow money for a specific purpose and pay it down over time.
While you can use the funds from a personal loan to cover any expense you want, these loans are best for people who have a big expense they need time to pay off. This could include surprise medical bills, a new motor for your car, or a roof you had no idea you would need to replace this year.
With a personal loan, you can borrow a set amount of money then pay it back over several years. Most personal loans are offered in amounts up to $35,000, and your interest rate could be as low as 3%, depending on your creditworthiness.
You’ve used a personal loan calculator to figure your new monthly payment, and you’re sure you can afford it.
Just because you qualify for a personal loan, that doesn’t mean you can afford it. Before you take out a personal loan, you should use a loan calculator to find out your future monthly payment based on how much you want to borrow and the interest rate you can qualify for.
From there, you can take a look at your budget and expenses to see if the loan payment stretches you too thin. If it does, you should probably hold off on getting a personal loan — at least for now.
Your credit is in good shape, so you can qualify for a loan with an attractive rate and loan terms.
While it’s possible to qualify for a personal loan if you have poor credit or a thin credit profile, you’ll pay a much higher interest rate for the privilege of borrowing. How much? Some personal loans for people with bad credit come with an APR of over 35%!
If you have bad credit, you may want to put off your personal loan until you can take steps to boost your credit score. Start by getting any late bills you have up to date and make sure you make all your other monthly payments on time. Paying down debt and credit card balances can also have a marked effect on your credit, since your utilization makes up 30% of your FICO score.
You want to consolidate high-interest debt into a new loan with a lower rate.
One of the best uses of a personal loan comes into play when you have a lot of high-interest debt. Of course, this is mostly just true if your credit is good enough to qualify for a personal loan with a great APR.
If you consolidate high-interest debt into a new personal loan with a lower, fixed interest rate, you’ll start saving money right off the bat. Going from several payments to just one each month can also simplify your finances and make debt repayment that much easier to bear.
When You Should Skip a Personal Loan
While any of the reasons above are good ones if you want to take out a personal loan, there are plenty of reasons to skip personal loans — or any other type of loan — altogether. There are also scenarios where a different financial product would be more beneficial.
Some of the reasons a personal loan may not be for you include:
You’re struggling to keep up with your debts and need more cash to stay afloat.
If you’re struggling to make payments on credit cards, student loans, or other bills, chances are good borrowing more money will not help. In fact, borrowing more cash just to stay on top of your expenses could lead to a debt spiral in a hurry. After all, adding one more monthly payment to your life is probably a bad idea when you can’t keep up with the payments you already have.
If you’re truly struggling to keep the lights on as it is, it’s probably wise to take a holistic look at your finances before you borrow money. Consider where you could cut to improve your cash flow and whether you need to switch to a bare bones budget for a while.
If you can cut your spending in any way, you may be able to improve your financial situation without borrowing more.
You need money to fund college tuition.
While there’s nothing wrong with borrowing money for college, a personal loan is rarely the best deal. Most borrowers would be a lot better off taking out federal student loans to pay for school since they offer lower fixed interest rates and federal protections like deferment and forbearance.
Federal student loans also qualify for income-driven repayment plans that come with low monthly payments and, in some cases, eventual forgiveness of your loans after 20 to 25 years.
You want to splurge for a vacation or new furniture.
If you want to splurge for something expensive, borrowing money could leave you in a world of hurt. A vacation to Hawaii may sound like something you won’t regret borrowing for. However, paying off that trip for the next several years would surely change your tune three or four years afterward.
There’s nothing wrong with splurging, but you should try to save up the money to pay in cash if you want to treat yourself. Trust us; buying something you truly want is a lot more fun when you pay with money you already have.
You want to refinance a small amount of debt.
We already mentioned how a personal loan can be used to consolidate high-interest debts into a better financial product. However, this is mainly true when you have a lot of debt to refinance and need several years to pay it down.
If you only owe a small amount of debt you could pay down in a few years or less, you may be a lot better off with a balance transfer card. Balance transfer cards offer 0% APR on balance transfers for up to 21 months. Some even come without any balance transfer fees, which can help you pay down debt without any additional costs.
You want to remodel your home.
If you want to remodel your home, a personal loan can absolutely work. Still, you should also consider a home equity loan. These loans work similarly to personal loans in that they offer a fixed interest rate and a fixed monthly payment for a specific set of time. The difference is, home equity loans are secured — meaning your home acts as collateral, making it less risky for the lender — so they usually offer lower interest rates than you can get elsewhere.
Another option is a HELOC, or home equity line of credit. These loans work as a line of credit you can borrow against, and they tend to come with variable rates. Once again, rates on these loans tend to be lower since you’re using your home as collateral.
Fees for both home equity loans and HELOCs tend to be low, but you should watch out for origination fees and closing costs. Also keep in mind that some home equity loans and HELOCs are offered with no fees and extremely low rates.
The Bottom Line
A personal loan could help you achieve myriad financial goals, but it could also cause as many problems as it solves. Before you apply for a personal loan, take stock of your financial position and make sure you know what you’re getting into. Personal loans can be valuable financial tools, but they can also lead to years of stress and debt.
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The post When You Should (and Shouldn’t) Use a Personal Loan appeared first on The Simple Dollar.