Pros And Cons Of Personal Loans – Forbes Advisor

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Understanding the ins and outs of personal loans is important when you are researching a lender and deciding whether to apply for financing. While personal loans can be helpful in a variety of situations, they can also come with high interest rates and a significant impact on your credit score. Still, the benefits of these loans can outweigh the risks — especially if you qualify for a competitive interest rate and need quick access to cash.

Regardless of your circumstances, here are tips to help you make that loan decision.

What is the benefit of a personal loan?

Personal loans can be an excellent option if you want to consolidate high-interest debt or need cash for a home improvement project or other major expense that you can afford to pay back. Not only are most personal loans unsecured – meaning no collateral is required by the lender – many are offered with competitive interest rates and no fees.

Still, there are some downsides to taking out a personal loan, so it’s important to assess your needs and the pros and cons of a personal loan before borrowing.

Benefits of Personal Loans

Personal loans can be extremely beneficial in the right circumstances. Personal loans can be beneficial because they:

1. Help borrowers build credit

Taking out a personal loan requires regular, monthly payments on the outstanding balance. Lenders typically report their payment records to the three major credit reporting agencies – Equifax, Experian, and TransUnion.

Consistently making payments on time can help improve your credit score; Payment history accounts for 35% of your FICO credit score. This also means that you can damage your score if you are late or delinquent on payments, making it harder to access credit in the future.

2. Make borrowers pay for purchases over time

Lenders pay personal loans as a lump sum upfront, which you can use to make a purchase or pay off another debt. This allows borrowers to make large purchases and then pay for them over time without saving money upfront. While this can be a good strategy for essential purchases, it can become dangerous if you’re relying on loans to go on vacation or cover other voluntary expenses.

3. Make debt consolidation easier

Debt consolidation loans allow borrowers to 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 keep track of each month, but it can also result in a lower overall interest rate if your credit score has improved since you took out your other loans.

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

Related: Pros and cons of debt consolidation

4. Can be used for almost anything

Personal loans are a popular financing option because they are so versatile and can cover everything from car repairs to home renovations to event-related expenses like weddings.

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

Related: 6 good reasons for a personal loan

5. Offer competitive prices

Annual percentage rates (APRs) on personal loans typically range from just 3% to 36%, with the most competitive rates reserved for highly qualified applicants. While the upper range of rates can get high, many applicants qualify for a lower APR than a standard credit card. However, these rates are still higher than secured loans such as home equity loans.

If you’re considering getting a personal loan, take the time to pre-qualify with the best lenders to see what kind of interest rate you’re likely to get.

Related: What is a good interest rate for a personal loan?

6. Offer flexible credit limits

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

7. Eliminate the need for collateral

Most personal loans do not require the borrower to post collateral. That means you don’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 usually come with higher interest rates and may be harder to qualify for because they pose a greater risk to lenders.

8. Provide quick access to cash

Processing and financing speeds for personal loans vary, but many lenders advertise same-day or next-day financing. So if you’re faced with unexpected car repair expenses or emergency travel needs, a personal loan can be a viable option.

However, if you are in urgent need of money, research the entire loan application process carefully. The actual time it takes to apply, be approved, and receive loan funds may be longer depending on when you apply, the size of the loan, and how quickly your bank gives you access to the funds after disbursement .

Disadvantages of personal loans

Borrowing can be a great way to cover expenses, but there are also some risks and downsides to taking out a personal loan. Before borrowing, remember that personal loans:

1. High interest charges apply

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

2. Come up with fees and penalties

In addition to interest rates, many lenders charge application fees and processing fees to cover processing costs. Likewise, penalties can be imposed on a borrower if they make a late payment or do not have enough funds to make the payment. Some institutions also charge prepayment penalties, but the most competitive lenders do not. When purchasing a personal loan, be aware of additional fees and penalties that can increase borrowing costs over the life of the loan.

3. Lead to credit damage

Just as lenders report a positive payment history to the credit bureaus, they also report late payments and non-payment. Because of this, borrowers who fail to make payments on time — or who default on the loan altogether — are likely to face lower credit ratings. In addition, taking out a personal loan increases a borrower’s balance, which accounts for 30% of your FICO credit score.

4. Demand collateral

If your credit rating is not good enough to qualify for a secured loan, you may need to pledge assets as collateral. This is most often the case for applicants who have a FICO credit score of less than about 585. With a secured personal loan, the lender can keep the collateral if you default. Common collateral includes assets such as a borrower’s home, car, boat, or certificate of deposit (CD).

5. Run into unnecessary debt

Depending on your reason for taking out a personal loan, this type of financing can result in unnecessary debt. Before committing to any loan, big or small, consider why you’re borrowing the money 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:

  • They have strong credit and 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-yield debts
  • Your Debt to Income Ratio (DTI) is 36% or less
  • You do not qualify for a 0% APR credit card
  • You are embarking on a project that will add value to your home

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