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When are personal loans a Good Idea?

They can be expensive However, they're usually your best option
By Tim Parker
Updated November 12, 2021
Review by Janet Berry-Johnson

A personal loan is a great option for almost anything. Some lenders may ask what you plan doing with your funds however, others want to be sure that you're in a position to pay it back. Although personal loans aren't cheap however, they are an option that is feasible in a variety of circumstances. Find out if one is right for you.
Important Takeaways

Personal loans can be used for almost any purpose.
Contrary to car loans however, personal loans typically are not secured by collateral.
Personal loans may be cheaper than credit cards and some other kinds of loans but they can be more costly than others.

How do personal loans work?

Some kinds of loans are specifically arranged to be used for specific purchases. It is possible to purchase a home by securing a mortgage, buy automobiles using an auto loan, and make payments for college using the student loan. When you take out a mortgage, your house acts as collateral. Similarly, with an auto loan the vehicle you purchase will serve as the collateral.

However, a personal loan often has no collateral. Because it is unsecured by the property which the lender could seize if you default on the loan the lender takes on a higher risk and will likely be able to charge you a higher rate of interest than with a mortgage or car loan. The amount you pay will be can depend on a number of factors that include your credit score as well as your debt-to-income ratio.1
Personal Loan Interest Rate Factors

Investopedia / Lara Antal

Personal secured loans are also available in some cases. The collateral could be your bank account, your car or any other asset. The secured personal loan could be simpler to obtain and has some of the lowest interest rates than an unsecured one. As with the other types of secure loan, you may lose the collateral you have secured if you are not able to make the monthly payments.

Even with an unsecured personal loan Naturally the inability to make timely payments can be harmful to your credit score and severely restrict your chances of getting credits in the future. FICO, the company behind the most frequently used credit score, claims that your payment history is the single most important element in their formula, accounting for 35% of your credit score.2
What are the best times to consider a personal loan

If you are considering a personal loan, you'll want to consider whether there may be less expensive ways you could take out the loan. A few good reasons to choose the personal loan include:

You don't have and couldn't qualify for a low-interest credit card.
The credit limits on your credit cards do not match your current borrowing requirements.
An individual loan is the cheapest borrowing option.
You don't have any collateral to provide.

You may also think about a personal loan if you need to borrow for a brief and clearly defined period of time. Personal loans typically run between 12 and 60 months.3 So, for example when you have a lump sum of money due within two years, but you do not have enough cash flow in the meantime the two-year personal loan might be an option to bridge that gap.

Here, for example, are five situations where an individual loan could be a good idea.
1. Consolidating Credit Card Debt

If you owe a substantial amount on one or more credit card with high interest rates, taking out an individual loan to pay these off can save you money. For instance, as of this writing, the average interest rate on credit cards is 19.49 percent, while the typical rate on a personal loan is 9.41%.1 That difference should allow you to pay off the debt quicker and pay less in interest over the course of. Plus, it's simpler to track and pay off one debt obligation rather than multiple ones.

However, the personal loan is not the only choice. In fact, you may be eligible to transfer your balances to a different credit card that has a lower interest rate If you meet the requirements. Certain balance transfer offers waive the interest for the duration that lasts for six months or more.
2. Paying Off Other High-Interest Debts

While a personal loan is more expensive than some other types of loans, it isn't necessarily the most costly. If you're a holder of an payday loan, for example it's likely to have a much higher interest rate than a personal loan from a bank. If you also have an older personal loan that has a higher interest rate than what you're eligible to receive today and you want to replace it with the new loan could help you save cash. Before you do, however ensure you determine if there's a penalty for early payment on the old loan or any application or origination fees on the new one. These fees could be significant.
3. The financing of a home Improvement or Big Purchase

If you're buying new appliances, installing a new furnace, or making a major purchase, taking out personal loan may be less expensive than financing through the seller or putting the bill on a credit card. However, if you have any equity built up within your house, then a homeowner equity loan or home equity line of credit could be more affordable. Of course, they are both secured debts and you'll be putting your house on the line.
4. The cost of a Major Life Event

As with every large purchase, financing a high-cost event, such as a bar or bat mitzvah or a significant anniversary celebration or wedding could be less expensive If you can pay for the occasion by using personal loan rather than a credit card. According to a study in 2021 by Brides and Investopedia, one in five U.S. couples will use loans or investments to pay for their wedding. While these weddings are important, as they are, you may consider reducing the amount slightly if you're going in debt for years to be. In the same way, taking out a loan to pay for a vacation may not be a great option unless it's the vacation of an lifetime.4

A personal loan could help boost your credit score if you are able to make all your payments on time. Otherwise, it will hurt your score.
5. Enhancing Your Credit Score

A personal loan and paying it back promptly could help improve the credit rating of your, especially if you have an history of missing payments on other loans. When your report shows mostly the credit cards, then taking out a personal loan might also help to improve your "credit blend." A variety of loans, and showing that you're able to handle them with care is considered to be an advantage for your score.5

That said, borrowing money that you don't need to improve the credit rating of yours is a risky option. It's better to continue paying all your others bills promptly and also trying to maintain the lowest credit utilization ratio (the sum of your credit you're currently using compared with the amount that's available to you).
The Bottom Line

Personal loans can be beneficial in the right circumstances. But they aren't cheap, and there are often better options. If you're thinking of getting one, the personal loan calculator can help determine how much it will cost you.
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