When Should You Take Out a Personal Loan?
You’ve likely seen the advertisements proclaiming “Quick payday loans” or “Take home cash in minutes!” These loans can be more costly than convenient and may end up harming your credit in the long run if you have trouble making repayments. However, in some instances a personal loan could be beneficial to you—or even your longer-term finances. Here’s how to determine when a personal loan may be right for you.
What is a personal loan?
While mortgages and student loans are designed to fund specific expenses, a personal loans is an open-ended type of loan. Lenders may ask you why you need to borrow a certain amount of money, but you can use it for just about any reason. You could pay off a variety of expenses, like credit card bills or rent, or even spend the money on shopping and travel. Also, unlike mortgage or auto loans, which use the property you’re funding as collateral (meaning the lender could seize the property if you default on repayments), personal loans don’t require any collateral. After all, personal loan funds are multipurpose, so there’s inherently no asset that can be used to back them up.
Should you consider one?
While there are businesses like payday loan centers that will gladly hand over cash with few questions asked, these loans tend to be extremely costly due to high interest rates, which make your monthly repayments potentially prohibitive. These interest rates can be as high as 400 percent!
However, even banks often extend personal loans at very high interest rates, so you should only take out a personal loan when absolutely necessary. Is the extra money essential to pay for emergency expenses like automotive or medical bills, or do you just think some extra cash would be nifty right now? While personal loans may seem like easy money, resist the urge to take out a loan if you have other options. You may end up hurting yourself in the long run by paying back a large sum of interest.
Exceptions to the rule
There may be cases in which taking out a personal loan would be your most advantageous option. For instance, you may be able to get a personal loan at a lower interest rate than a credit card, depending on market conditions. You can avoid paying credit card interest by paying off your balance in full each month, but if you don’t, you could be on the hook for more money. If you expect that to be the case, a lower-interest personal loan may be a wiser option to pursue.
Additionally, people with little credit experience may have trouble getting approved for a credit card at all, meaning a personal loan may be their only borrowing option. And in cases when you need extra money to make necessary payments, taking out a personal loan is often better than failing to make said payments on time. Getting behind on medical payments, for example, can result in your balance transferring to a collections agency, which is extremely costly and can seriously impact your credit score. Failing to make timely payments to the IRS, meanwhile, can result in legal penalties. The extra interest on a taking out a personal loan would be of far less consequence.
What affects your interest rate?
Your interest rate is directly related to how much the lender perceives you to be a risk. Because a personal loan has no collateral, the lender is risking their funds by issuing a loan and thus charges an interest rate based on their faith in you to make repayments. While some lenders set a lofty interest rate and high fees for all clients, traditional lenders like banks use the following factors to determine your interest rate.
Credit score
As with just about any type of loan, your credit score is crucial to your interest rate. A credit score above 670 is generally considered “good,” while a score above 800 means you’re a trustworthy borrower. Make timely payments on all of your lines of credit to boost your credit score.
Employment status
Lenders use your employment status to determine if you can reasonably pay back a loan. If you are unemployed, work part-time, or have a varying income due to contract/freelance work, you may face a higher interest rate.
Debt-to-income ratio
How much debt do you currently have? While many Americans owe lenders for their mortgage or auto loans, excessive debt may sway lenders to believe that you can’t repay a personal loan.
Loan amount and term
How much money do you need, and in how much time could you reasonably pay off the principal amount (the total money you borrowed, not including interest costs)? The less you borrow and the shorter the term, the less you may end up paying in the long run.
Where to apply for a loan
If you decide that a personal loan is right for you, reach out to your bank first. Banks may offer lower interest rates to their existing customers and can loan you anywhere from a few hundred dollars to over $50,000. These institutions will also walk you through the terms, risks, and responsibilities of a personal loan in sufficient detail so you will know exactly what you’re getting into.