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When Are Personal Loans a A Good Idea?

They're not cheap However, they're usually the best choice.
By Tim Parker
Updated November 12, 2021
The review was written by Janet Ber-Johnson.

A personal loan can be used for almost anything. Some lenders will ask what you intend for the cash while others want to be sure that you're able to pay back the loan. While personal loans aren't cheap however, they are an option that is feasible for a wide range of situations. Here's how to decide whether one is the best option for you.
Important Takeaways

Personal loans can be used for almost any purpose.
Contrary to car loans Personal loans generally aren't secured with collateral.
Personal loans may be cheaper than credit cards, and other kinds of loans but they can be more costly than others.

What are the Personal Loans and how they work

Some types of loans are specifically arranged to be used for specific purchases. You could buy a house with a mortgage, purchase automobiles with an auto loan or take out an undergraduate loan. If you have a mortgage, your home serves as the collateral. Similar to an auto loan the car you purchase will serve as the collateral.

However, the personal loan typically does not have collateral. Because it's secured by the property which the lender can seize in case you fail to repay the loan the lender is taking on greater risk and will likely be able to charge you a higher interest rate than it would with a car or mortgage loan. Just how high your rate will be will depend on several factors that include your credit score and debt-to income ratio.1
Personal Factors affecting the Interest Rate of a Loan

Investopedia / Lara Antal

Personal loans are also available in some cases. The collateral could be your bank account, car or any other asset. The secured personal loan might be easier to obtain and has an interest rate that is lower than an unsecured one. As with every other type of secured loan it is possible to lose your collateral if unable to keep up with the repayments.

Even with an unsecured personal loan Naturally the inability to make timely payments can be harmful to your credit score, and may limit your ability to obtain credits in the future. FICO, the company behind the most frequently used credit score, says that your payment history is the single most important factor in its formula, which accounts for 35 percent of the credit score.2
If you are considering a personal Loan

Before you opt for the personal loan you should look at alternatives that are less costly to take out a loan. The most acceptable reasons to consider the personal loan are:

You don't need and can't be eligible for a low-interest credit card.
The credit limits on your credit cards do not match your current borrowing requirements.
Personal loan is the least expensive borrowing option.
You don't have any collateral to offer.

It is also possible to consider a personal loan if you need to borrow for a fairly limited and defined amount of time. Personal loans generally range from 12 to 60 months.3 For instance, if you have a lump sum of money due within two years, but you do not have enough cash flow in the meantime, a two-year personal loan may be a viable option to fill the gap.

Here, for example, are five circumstances when the personal loan could be beneficial.
1. Consolidating Credit Card Debt

If you are owed a significant balance for one of your credit cards that have high interest rates, getting an individual loan to pay these off could help you save money. For instance, as of this writing, the median interest rate on a credit card is 19.49%, while the rate for a personal loan is 9.41%.1 This difference will allow you to pay down the balance more quickly and pay less interest overall. Additionally, it's simpler to track and pay off one debt, rather than several ones.

However, taking out a personal loan is not your only option. You may be capable of transferring your balances to a new credit card that has an interest rate that is lower, if you qualify. Certain balance transfer offers waive the interest for a promotional period that lasts for six months or more.
2. Repaying other high-interest debts

While a individual loan is more expensive than some other types of loans, it isn't necessarily the most costly. If you're in possession of a payday loan, for example it's likely to have a much higher interest rate than the personal loan from a bank. If you also have an old personal loan that has a higher interest rate than the one you qualify to receive today and you want to replace it with the new loan can save you money. Before doing this, however, be sure to determine if there's a penalty for early payment on the old loan or application or origination charges on the new loan. These fees could be substantial.
3. The financing of a home Improvement or major Purchase

If you're buying new appliances, installing a new furnace, or making a major purchase, taking out an individual loan may be less expensive than financing with a seller or placing the purchase on credit card. However, if you've got any equity built up in your home, a home-equity loan or home equity line of credit might be more affordable. Of course, these are both secured which means you'll have to put your house on the line.
4. The cost of an Major Life Event

Like every major purchase, financing an expensive occasion, like a bar or bat mitzvah, an important anniversary celebration or wedding may be less costly If you can pay for it using a personal loan instead of credit cards. According to a survey in 2021 by Brides and Investopedia, one of five U.S. couples will use loans or investments to help to pay for their wedding. However important these occasions are, you might be thinking about reducing your budget slightly if you're going into debt for a long time to be. For that same reason, borrowing to fund a vacation isn't a good idea, unless it's the trip of a lifetime.4

A personal loan could help boost your credit score, if you pay all your payments on time. Otherwise, it will affect your credit score.
5. Improving Your Credit Score

A personal loan and paying it back promptly could help improve your score on credit, especially when you have a history of missed payments on other debts. If your credit report shows mostly credit card debt, then taking out a personal loan might also help the "credit mix." A variety of loans and proving that you are able to manage them in a responsible manner is considered to be an advantage for your score.5

That said, borrowing money you don't really require in hopes of improving you credit standing is a dangerous idea. It is better to pay your autres bills in time while striving to keep an acceptable percent of your credit's utilization (the sum of your credit you are using at any given time in comparison to the credit that's accessible to you).
The Bottom Line

Personal loans are a good option if they're in the right circumstances. However, they're not cheap, and there are often better options. If you're thinking about one, the Investopedia personal loan calculator can help determine what it will cost you.
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