The Pros and Cons of Personal Loans: A Complete Guide

Personal loans allow you to borrow money for any purpose. They offer easy access to financing, competitive rates, and flexible terms. However, personal loans also come with risks like high interest and potential damage to your credit. In this comprehensive guide, we’ll explore the pros and cons of personal loans to help you make an informed borrowing decision.

What is a Personal Loan?

A personal loan is an installment loan from a bank, credit union, online lender, or other financial institution. The lender provides a lump sum of cash upfront, which you repay in fixed monthly payments over a set repayment term, usually between 2 and 7 years

Personal loans differ from other types of consumer loans because they are unsecured This means you don’t have to pledge any collateral to get approved As a result, personal loans pose more risk for lenders, which can result in stricter eligibility requirements and higher interest rates compared to secured loans like auto loans or mortgages.

The Pros of Personal Loans

While personal loans do carry some risks they also offer many potential benefits

1. Fast access to cash

One of the biggest advantages of personal loans is that they provide quick access to financing. Many lenders advertise next business day funding once approved, making personal loans a great option when you need money fast.

2. Can be used for anything

Personal loans offer versatility. You can use the funds for virtually any personal expense like medical bills, home improvements, debt consolidation, vacations, and more. Just be sure to borrow responsibly and avoid creating unnecessary debt.

3. Fixed payments

Personal loans feature fixed interest rates and monthly payments. This makes it easy to budget for repayment and avoid payment shock down the road as interest rates fluctuate.

4. May help improve your credit

Making consistent on-time payments can help boost your credit score over time. This is because most lenders report your payment activity to the major credit bureaus.

5. No collateral required

Personal loans don’t require you to put up any valuable assets as collateral. This reduces the risk of losing your property if you default. However, it also means lenders view personal loans as riskier, so you may pay more in interest.

6. Consolidate high-interest debt

Consolidating multiple debts into one personal loan can simplify your finances and potentially lower your interest rate. This helps pay off debt faster and save money over time.

7. Competitive rates

While not as low as mortgages or auto loans, today’s personal loan rates are competitive, with many borrowers qualifying for rates under 10%. Be sure to shop around for the best rate you can get.

8. Predictable payoff

Personal loans have set repayment terms, usually between 2 and 7 years. This lets you easily calculate when the loan will be fully paid off.

9. Build credit history

Making on-time payments shows potential lenders you can responsibly manage debt. In addition to boosting your credit score, a positive payment history on a personal loan can help qualify you for other loans in the future.

The Cons of Personal Loans

Personal loans provide easy access to financing, but they aren’t without drawbacks. Consider these potential downsides before getting a personal loan:

1. High interest rates

Personal loan rates can be expensive, ranging anywhere from 5% to 36% APR. Make sure you qualify for the lowest rate possible by comparing multiple lenders and maintaining a strong credit score.

2. Shorter terms mean higher payments

Most personal loans have repayment terms under 5 years. The short timeline means your monthly payments will be higher compared to longer-term installment loans like mortgages. Make sure the payment fits comfortably in your budget.

3. Can damage your credit if mismanaged

Missed or late payments will hurt your credit, and having a personal loan increases your credit utilization. This can negatively impact your credit score if you take on more debt than you can realistically afford to repay.

4. Prepayment penalties

Some personal loans charge you a penalty fee if you pay off your loan early. Be sure to ask about prepayment policies before signing your loan agreement.

5. Difficult to discharge in bankruptcy

While not impossible, personal loans are treated as low priority debt in bankruptcy. This makes them more difficult to discharge than credit card or medical debt.

6. Less oversight on how you spend funds

Lenders deposit the loan directly into your account without restrictions on how you can spend it. This freedom makes it easier to misuse loan funds on unnecessary purchases. Make sure you have a clear borrowing purpose before getting a personal loan.

7. Risk of default and collections

If you fail to repay your personal loan, the lender can place your account into collections, garnish your wages, and pursue other avenues to get repaid. Defaulting will severely hurt your credit score and finances.

Who Should Get a Personal Loan?

Here are a few examples of good cases for getting a personal loan:

• Consolidating high-interest credit card balances – Personal loans often offer lower rates than credit cards, helping you save money on interest charges.

• Financing a home improvement project – Whether it’s a new roof, updated appliances, or remodeling, personal loans allow you to pay for upgrades over time.

• Covering emergency expenses – Unexpected bills like medical treatment or car repairs can be covered with a personal loan when you don’t have savings on hand.

• Smooth out irregular income – If you work seasonally or rely on bonuses/commissions, a personal loan can provide cash flow until the next infusion of funds.

• Build your credit history – Responsibly managing a personal loan can help build your credit profile if you have limited or poor credit history.

Who Should Avoid Personal Loans?

Here are a few cases where personal loans may not be advisable:

• If you can get lower rate financing elsewhere – Home equity loans/lines, 401(k) loans, and 0% credit cards offer cheaper alternatives.

• To pay off low-interest long term debt – It rarely makes sense to trade low-rate installment loans like student loans or auto loans for a higher-rate personal loan.

• If you have poor credit – Those with credit scores below 580 will pay very high rates and likely need a co-signer, which is risky.

• To fund unnecessary purchases – Frivolous spending can quickly spiral out of control. Avoid personal loans for wants vs. needs.

• If you’re already struggling with debt – Additional borrowing will just worsen the situation. Get professional help managing expenses and existing debts first.

• You can’t afford the monthly payments – Make sure your budget has room for another monthly bill before taking out a personal loan.

Tips for Getting the Best Personal Loan Deal

Follow these tips to secure the most affordable personal loan:

• Check your credit – Good credit scores (680+) qualify for lower rates. Review your credit reports for errors before applying.

• Compare multiple lenders – Each lender uses different criteria to set rates, so shop around for the lowest APR.

• Focus on local lenders – Nearby banks and credit unions may offer better rates and personalized service.

• Apply with a co-signer – Adding a creditworthy co-signer can help you qualify for more favorable loan terms.

• Minimize fees – Avoid lenders that charge application or origination fees, which increase your overall borrowing costs.

• Explain any credit blemishes – If you have late payments or collection accounts, add notes explaining what happened to help your case.

• Reduce credit card balances – Higher credit utilization rates can negatively impact your personal loan terms.

• Ask about discounts – Some lenders offer interest rate reductions for setting up autopay, having an existing account, or other qualifications.

The Bottom Line

Personal loans provide an accessible way to finance large purchases, consolidate debt, cover emergencies, and more. But before borrowing, make sure you understand the pros and cons. While personal loans offer convenience, they also come with risks like high interest, short repayment terms, and potential credit damage. Carefully compare loan offers, maintain a reasonable loan amount, and budget for repayment to get the most benefit from a personal loan while minimizing financial risk.