Pros And Cons Of Personal Loans – Forbes Advisor

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Understanding the pros and cons of personal loans is important when shopping for a lender and deciding whether to apply for financing. While personal loans may be helpful in several situations, they can also come with high interest rates and major repercussions for your credit score. Even so, the benefits of these loans may outweigh the risks—especially if you qualify for a competitive rate and need quick access to cash.

Regardless of your circumstances, here are tips to help you navigate this borrowing decision.

What Is the Benefit of Obtaining a Personal Loan?

Personal loans can be an excellent option if you want to consolidate high-interest debts or need cash for a home improvement project or other major expense and can afford repayment. Not only are most personal loans unsecured—meaning the lender doesn’t require collateral—many come with competitive interest rates and zero fees.

Still, there are some downsides to taking out a personal loan, so it’s important to evaluate your needs as well as personal loan advantages and disadvantages before borrowing.

Pros of Personal Loans

Personal loans can be extremely advantageous under the right circumstances. Personal loans may be beneficial because they can:

1. Help Borrowers Build Credit

Taking out a personal loan requires making regular, monthly payments toward the outstanding balance. Lenders typically report your payment record to the three major credit bureaus—Equifax, Experian and TransUnion.

If you consistently make on-time payments, this can help increase your credit score; payment history accounts for 35% of your FICO credit score. This also means you can damage your score if you make late payments or default, making it harder to access credit in the future.

 

2. Let Borrowers Pay for Purchases Over Time

Lenders disburse personal loans as a lump-sum upfront that you can use to make a purchase or pay off another debt. This enables borrowers to make large purchases and then pay for them over time, without saving money in advance. While this can be a good strategy for necessary purchases, it may become dangerous if you rely on loans to go on vacation or cover other discretionary spending.

3. Make It Easy to Consolidate Debt

Debt consolidation loans let borrowers streamline their finances by paying off individual loans and credit card balances with a single personal loan. Not only does this reduce the number of payments you have to remember each month, but it may also result in a lower overall interest rate if your credit score has improved since taking out your other loans.

Some lenders specialize in debt consolidation and will directly pay off your other debts instead of disbursing cash to your account.

Related: Pros And Cons Of Debt Consolidation

4. Be Used for Almost Anything

Personal loans are a popular financing option because they are so versatile, and you can use them to cover everything from auto repair costs to home improvements and event-related expenses, like weddings.

Acceptable loan uses vary by lender, but most institutions allow borrowers to use funds for any personal, family or household purposes. Personal loans may not be used to further illegal activity. Some lenders also restrict whether personal loan funds can be used to purchase real estate, pay for post-secondary education or start a new business.

Related: 6 Good Reasons To Get A Personal Loan

5. Offer Competitive Rates

Personal loan annual percentage rates (APRs) typically range from just 3% up to 36%, with the most competitive rates reserved for high-qualified applicants. While the upper range of rates can get high, many applicants qualify for an APR lower than what is available with a standard credit card. However, these rates are still higher than secured loans like home equity loans.

If you’re considering whether to get a personal loan, take time to prequalify with top lenders to see what kind of rate you’re likely to get.

Related: What Is A Good Interest Rate On A Personal Loan?

6. Provide Flexible Borrowing Limits

Borrowing limits vary by lender, but personal loans are typically available between $1,000 and $100,000. For that reason, personal loans can be tailored to meet the borrowing needs of most consumers. Just keep in mind that getting a $100,000 personal loan will likely be more challenging than qualifying for a smaller, less risky sum. Alternatively, if you’re planning to finance a smaller purchase, a credit card or point-of-sale financing may be the better option.

7. Eliminate the Need for Collateral

Most personal loans do not require the borrower to pledge any collateral. This means you won’t have to risk losing a valuable asset—like your home or car—if you default on the loan. However, keep in mind that unsecured loans typically come with higher interest rates and may be more difficult to qualify for because they pose more risk to lenders.

8. Provide Fast Access to Cash

Personal loan application processing and funding speeds vary, but many lenders advertise same- or next-day funding. So, if you’re facing unexpected auto repair costs or emergency travel needs, a personal loan may be feasible.

However, if you need funds in a hurry, carefully research the entire loan application process. The actual time it takes to apply, get approved and receive loan funds can be longer depending on when you apply, the size of the loan and how quickly your bank lets you access the money after it is disbursed.

Cons of Personal Loans

Loans can be a great way to cover expenses, but there are also some risks and drawbacks of taking out a personal loan. Before borrowing, consider that personal loans may:

1. Accrue High Interest Charges

While the most creditworthy personal loan applicants can qualify for low APRs, others may encounter higher rates up to 36%. Depending on your loan offer, this rate may be much higher than rates available through other types of financing, like home equity loans, home equity lines of credit (HELOC), student loans and 0% APR credit cards. Consider all of the alternatives to personal loans before signing on the dotted line.

2. Come With Fees and Penalties

In addition to interest rates, many lenders charge application fees and origination fees to cover the cost of processing. Likewise, a borrower may encounter penalties for making a late payment or having insufficient funds for payment. Some institutions also charge prepayment penalties, although the most competitive lenders do not. When shopping for a personal loan, keep an eye out for additional fees and penalties that may increase the cost of borrowing over the loan term.

3. Lead to Credit Damage

Just as lenders report positive payment history to credit bureaus, they also report late payments and nonpayment. For that reason, borrowers who fail to make on-time payments—or who default on the loan altogether—are likely to find themselves with a lower credit score. What’s more, taking out a personal loan increases a borrower’s balance, which accounts for 30% of your FICO credit score.

4. Require Collateral

If you don’t have a high enough credit score to qualify for a secured loan, you may have to pledge assets as collateral. This is most often the case with applicants who have a FICO credit score below around 585. In the case of a secured personal loan, the lender can keep the collateral if you default. Common collateral includes assets like a borrower’s house, car, boat or certificate of deposit (CD).

5. Result in Unnecessary Debt

Depending on your reason for getting a personal loan, this type of financing can lead to unnecessary debt. Before you commit to a loan—big or small—evaluate why you’re borrowing the funds and whether a personal loan is the best solution.

Is a Personal Loan Right for You?

A personal loan may be right for you if:

  • You have a high credit score and will help you qualify for a low interest rate
  • There is room in your budget for a new monthly payment
  • You want to consolidate multiple, high-interest debts
  • Your debt-to-income (DTI) ratio is 36% or less
  • You won’t qualify for a 0% APR credit card
  • You’re tackling a project that will add value to your home

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