When people normally write about debt, they discuss mortgages, car loans, and credit cards. Mortgages and car loans are secured debt – the amount you borrow is backed by the asset, and if you don’t pay the lender can take that asset. Credit cards are unsecured and the amount of your credit limit is based on your past credit usage (as determined by your credit score).
Another type of unsecured loan that isn’t talked about as much is the personal loan. This is an installment loan – you make payments over time – providing a fixed amount of money that you can use for whatever reason you deem necessary: home repair, a wedding, a trip, or even to purchase a new car. Repayment terms usually range between one and ten years. Interest rates can vary from a competitive low rate (often one or two percentage points above mortgage rates) for those with excellent credit to rates higher than a credit card for people with bad credit.
Why consider a personal loan
Flexibility and no collateral. I mentioned this above, but a personal loan can be used for almost anything and requires no collateral.
Interest rate “sweet spot”. Usually, interest rates for personal loans fall between the loans for mortgages and those for credit cards. Recently, while credit card interest has surpassed 17% on average, the interest rate for personal loans came in at 9.39%.
The rate may change based on what you use the loan for. For instance, when I ran some numbers on bankrate.com and answered that I would use the loan to consolidate my debt, the interest rate at the leading bank was 5.99%. When I changed that to home improvement, the interest rate dropped to 3.99%.
Ease of use. Whether consolidating debt from several credit cards or paying for a large purchase, personal loans let you make one payment every month over a set amount of time. You don’t have to worry about which card to pay down first or how you’re going to save for that bathroom remodel.
Build positive credit history. Like other unsecured loans (credit cards), paying off a personal loan on time every month will help your credit score, as the majority of banks report this information to the credit bureaus. Managed correctly, using a personal loan to consolidate your high-interest credit card debt can be a valuable step in increasing your score if you’ve had a history of making late payments on your credit cards.
Why a personal loan may not be for you
Interest rate shock. For those with good credit, personal loans may fall in the sweet spot between a mortgage/auto loan and a credit card. For those with poor credit, interest rates for a personal loan may in fact be substantially higher than your credit card rate. If you have poor credit, consider other options and work on building up your credit score. At the very least, read the loan paperwork thoroughly to understand the rate you’ll be paying.
Payment surprise. If you’re moving from a credit card world to a personal loan world, you may be in for a surprise. Credit cards provide a minimum payment you can make if cash is tight and you don’t have enough to pay the full amount. Personal loans don’t offer that. Like a mortgage or car loan, if you can’t make the payment in full every month you may risk defaulting on the loan.
Fees and penalties. As with interest rates, make sure you compare fees between the loan options (some are no fee, some charge you 5% or more of the loan amount just to open the loan). Similarly, if you are late making payments, most loans have built-in penalties even if you manage to catch up in the next few months. Like I said above, read all documentation carefully. You may even be surprised to find a prepayment penalty exists if you want to pay the loan off early.
Build a negative credit history. Just as on-time in-full payments can help your credit rating, late or missing payments will ding your rating.
Too easy. Like most financial products out there, the use of a personal loan entirely depends on you. When you’re considering this, look honestly at how you’ve handled debt (especially credit card debt) in the past. Are you grasping at straws hoping that you can change your spendthrift ways? Or do you have a plan to stop overspending and are using this to get out of credit card debt once and for all? These loans are easy, especially if you still have a decent credit rating. Don’t let easy money tempt you into buying a boat you can’t afford or going on a trip just because you deserve it. I read a great line on the Marcus.com website – a personal loan “is a tool, not a cure for spending.”
Is a personal loan the right tool?
To determine if a personal loan will work for you, here are a few questions to ask yourself:
- How much do you absolutely need? When you plug that amount into online calculators, what’s the payment? Can you afford that payment added onto your current expenses?
- If you’re consolidating debt, how will you stop spending? If you move your balance to a personal loan, will having a zero-balance credit card be too tempting?
- For home improvement, will this add value to your home? Have you compared a home equity loan or a home equity line of credit to the personal loan to see which provides better terms?
Spend some time researching these loans, especially if you’re not familiar with them. Look not only at what your payment might be, but how the loan is structured and all fees and penalties. Personal loans can be the right tool in many situations. Before signing the paperwork, make sure it is for you.
Photo by Daniel Thomas