The Pros and Cons of Personal Loans

For consumers, personal loans can bring mixed blessings. A personal loan can help you finance a large purchase or consolidate credit card debt into a single fixed monthly payment. But as with any financial product, there are also drawbacks. Some lenders charge high interest rates, for example, which will only end up increasing the costs of borrowing, and your credit score may take a hit.

So before you take out a personal loan, it’s a good idea to look over the pros and cons in order to determine whether this will be the right choice. Here are tips intended to help you decide whether to take out a personal loan.

[Read: Best Personal Loans.]

What Is the Benefit of a Personal Loan?

If you need cash for a home improvement project or to pay off medical expenses — and can afford to repay — personal loans can be a great option. Many personal loans boast competitive interest rates and zero fees. Also, most personal loans are unsecured, which means the lender won’t require any collateral from you.

But because there are also downsides, you’ll need to look at your needs while evaluating the pros and cons of personal loans before choosing to borrow.

Personal Loan Pros

Credit-building. When you take out a personal loan, you are required to make consistent monthly payments toward the outstanding balance. These payments are usually reported by the lender to the three major credit bureaus: Experian, TransUnion and Equifax. Your payment history accounts for 35% of your FICO credit score, so if you’re making on-time payments on a regular basis, your credit score can increase.

Paying over time. Personal loans are dispersed upfront as a lump sum that can be used to make a purchase or to pay off a debt. Borrowers can then make large purchases and end up paying for them over time, without going through the process of saving money beforehand. This can be a good idea for necessary purchases, but if you end up relying on personal loans to go on vacation or to cover debt from a recent shopping spree, the loans could turn into something dangerous.

Debt consolidation. If you’re looking to pay off individual loans and credit card balances with a single personal loan, consider taking out a debt consolidation loan. This type of loan reduces the number of payments you’ll have to remember each month. Also, if your credit score has increased since you took out the other loans, you may receive a lower interest rate. If you don’t want cash disbursed into your bank account, some lenders will directly pay off your debts.

But if you use a loan for this reason, you will need to put away your credit cards, says Jeffrey Edwards, certified financial planner and president of Atlas Financial Planning in Irvine, California. That way, you’re not running up debt while you’re trying to pay it off.

Versatility. While some loans can only be used for certain purposes — such as a car loan — personal loans can be used for virtually anything, from consolidating debt to funding a wedding. Acceptable loan use will vary by lender, but most financial institutions will allow borrowers to use their funds for nearly any personal, family or household expense.

Competitive rates. Compared with credit cards, personal loans often come with lower interest rates. Annual percentage rates for personal loans tend to range from 3% to 36%. Highly qualified applicants usually receive the most competitive rates. Even though the upper range of APRs can get high, many applicants will end up qualifying for a lower APR than that charged by a credit card. You’ll save money on interest if you have good credit and take out a personal loan instead of using a credit card. Take the time to prequalify with lenders to see what rate you’ll likely receive.

Flexible limits. Personal loans are typically available between $1,000 and $100,000, depending on the borrowing limits set up by various lenders. This wide range makes it possible for borrowers to tailor the amount to their specific needs.

Extended loan terms. Personal loans usually have loan terms that range from two to 10 years, depending on the lender. This allows the borrower to adjust the monthly payment — a longer term normally means a lower payment. However, the longer the loan term, the more interest you’ll end up paying over the life of the loan.

Access to fast cash. The processing of personal loans and the speed of funding will vary, but many lenders boast same- or next-day funding. If you find yourself facing unexpected medical costs or emergency home repairs, a personal loan may solve your problems quickly.

Easier-to-manage payments. Compared with having several credit cards with varying interest rates and due dates to pay off a debt, a personal loan that comes with a single, fixed-rate monthly payment is easier to manage. If you qualify for a personal loan with a lower interest rate than your credit cards, you can streamline your monthly payments while saving money.

Personal Loan Cons

High interest charges. Personal loan applicants with good credit can expect to qualify for a low APR, but others with poor credit may encounter high rates that can go up to 36%. This rate could end up being higher than financing alternatives, such as home equity loans or 0% APR credit cards. A bad-credit borrower could end up paying thousands of dollars more in interest compared with someone with good credit.

Fees and penalties. Lenders may charge origination fees and application fees that can increase the cost of borrowing. Tom Parrish, head of retail lending product management at BMO Harris Bank, says you should compare origination fees, which range from 1% to 6% of the loan amount.

These fees may be included in the loan or subtracted from the disbursement amount. Along with fees, there are penalties. Borrowers may face penalty charges for a late payment or having insufficient funds for payment.

Credit damage. Lenders report late payments and nonpayment to credit bureaus, so borrowers who are struggling to pay back their loan — or who end up defaulting on the loan — will likely find themselves with a lower credit score. Also, when you apply for the loan, the lender will conduct a hard-credit inquiry, which will knock down your score a few points.

Debt. Taking out a personal loan can lead to a large amount of debt. It’s important to understand why you’re borrowing the funds and whether taking out a personal loan is the best solution for you and your finances.

Eligibility requirements. If you have bad credit, it may be difficult to qualify for a personal loan, decreasing your lender choices. If you’re counting on a co-signer to strengthen your chances, you may have to think again, since some lenders don’t allow co-signers.

Higher payments. Personal loans may come with a higher fixed monthly payment than credit cards and also must be paid off by the end of the loan term. If your finances are tight, these higher monthly payments can be difficult to manage, and you may be at risk of defaulting on the loan.

Ask yourself whether you can truly afford the loan and whether the payment will affect other financial goals. That could include saving for retirement, growing your emergency fund or setting aside money for a major purchase, says Angie Furubotten-LaRosee, a certified financial planner with Avea Financial Planning in Richland, Washington.

[READ

: Best Debt Consolidation Loans.]

Alternatives to a Personal Loan

Before you take out a personal loan, make sure you consider some of these alternatives:

Home equity loan or line of credit. You can choose to receive your money in a lump sum right away with a home equity loan or open a revolving line of credit also known as a HELOC. Because both types of loans are secured by your home, the interest rates will likely be lower than the rate for a personal loan. But if you have a problem paying the loans, your home could be at risk.

401(k) loan. If you borrow against your retirement earnings, you will need to pay back whatever you access, with interest, though you are paying yourself. This loan has a couple of risks. If you lose your job, you’ll have to pay back the money by the next tax filing deadline, and the amount you remove will miss out on any possible market gains.

Low-interest credit cards. You can transfer your high-interest balance from one credit card to a new one with a promotional 0% APR. This approach can work if you’re disciplined with your spending. “If you transfer the balance from a high-interest-rate to a no-interest-rate (card) for 12 months, use that opportunity to pay that debt as quickly as possible in that 12 months,” Edwards says.

[CALCULATE

: Use Our Free Loan Calculator to Estimate Your Monthly Payments.]

Is a Personal Loan Right for you?

A personal loan could be the right choice if you:

— Want to consolidate debt.

— Have good credit and qualify for low interest rates.

— Prefer to borrow without pledging collateral.

— Want quick approval and disbursement.

More from U.S. News

What Credit Score Do You Need for a Personal Loan?

How to Get a Low Interest Rate on a Personal Loan

How to Prequalify for a Personal Loan

The Pros and Cons of Personal Loans originally appeared on usnews.com

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