The Pros and Cons of Personal Loans: Everything You Need To Know

Personal loans allow you to borrow money for any purpose, which can be useful in many situations. However, they also come with some potential downsides to be aware of. In this comprehensive guide, I’ll walk through the key pros and cons of personal loans to help you determine if one is the right financing option for your needs.

Pros of Personal Loans

Here are some of the main benefits that personal loans offer

1. Flexible Use of Funds

One of the best features of personal loans is that they can be used for almost anything. Common uses include:

• Consolidating high-interest debt
• Funding home improvements or repairs
• Paying for medical procedures not covered by insurance
• Financing a wedding, vacation, or other large expense
• Making a major purchase like an engagement ring
• Covering emergency costs

You aren’t limited to specific purchase types like you are with auto loans or mortgages The flexibility makes personal loans applicable in many different financial situations

2. Fixed Interest Rates and Payments

Most personal loans come with fixed interest rates, meaning your monthly payment stays the same over the full loan term. This predictability makes it easy to budget for the repayment.

Variable rate loans may start with a lower rate, but it could increase over time, raising your monthly payments. The stability of fixed rate loans helps avoid this payment shock.

3. Fast Access to Funds

You can often get funds from a personal loan within just 1-7 days of approval. This rapid funding makes personal loans a good option when you need money quickly for pressing financial needs.

The quick process is facilitated by the fact that personal loans don’t require collateral like a house or car title. The lender’s risk is higher, but in turn you get faster access to funds.

4. Potentially Lower Rates Than Credit Cards

Personal loan rates are often considerably lower than credit card interest rates. The average credit card APR is currently around 16% to 25% while personal loan rates range from around 6% to 36%.

People with good credit (scores of 690 or higher) can usually qualify for personal loan rates on the lower end of that range. This makes personal loans a cheaper way to borrow, especially for large amounts.

5. May Improve Credit Scores

Making consistent on-time personal loan payments shows you can responsibly manage installment loan credit. This type of credit mix can help boost credit scores over time.

However, it’s important to keep utilization low on other revolving credit accounts like credit cards. Adding a new installment loan while maxing out cards can actually lower scores initially.

6. Unsecured Funding Source

Personal loans don’t require you to risk any of your assets as collateral. This gives you access to unsecured funding that doesn’t tie up home equity or vehicle titles.

Lenders provide unsecured loans based on creditworthiness alone. That avoids complications if you were to later default on the loan and lose your collateral.

7. Consolidate Debts at Lower Rate

One of the most popular uses for personal loans is consolidating credit card balances. By rolling multiple high-rate cards into a personal loan, you can slash interest costs and simplify managing just one payment.

This debt consolidation approach only works if you stop using the paid off credit cards. Otherwise, you could end up with as much debt as before. Commit to not racking up new card balances.

8. Co-Borrower Option

Some lenders allow applying for a joint personal loan with a co-borrower even if you don’t qualify solo with your own income or credit score. Adding a co-borrower strengthens the application.

Apply with a spouse, family member, or trusted friend with better finances. Their qualifications combined with yours may meet requirements for approval and a lower rate.

9. Avoid Prepayment Penalties

Personal loans don’t charge prepayment penalties for paying off the balance early. This flexibility allows making extra payments to pay down principal faster without penalty fees.

Paying more than the monthly amount due shortens the repayment term and reduces total interest costs. Review loan terms to confirm there’s no prepayment penalties before borrowing.

Cons of Personal Loans

While personal loans offer useful benefits, there are also some potential disadvantages to consider:

1. Borrowing Increases Total Debt

The new loan principal immediately raises your total debt level. This higher debt-to-income ratio can make it harder to qualify for additional financing until you pay down the balance.

Too much total debt compared to your income looks risky to other lenders. Keep loan amounts reasonable to maintain healthy DTI ratios for borrowing again in the future if needed.

2. Missed Payments Hurt Credit Scores

Just as on-time payments can help credit, missed or late payments on a personal loan can significantly hurt scores. Even one late payment can drop scores by up to 100 points or more.

Payment history is typically the biggest factor in credit scores. Borrowers with less-than-perfect payment histories on other accounts should beware taking on new installment loan payments they may struggle with.

3. Loan Balance Doesn’t Go Away if Used Up

Unlike credit cards, the full personal loan amount is distributed upfront in one lump sum. If you use up all the funds but still need money, you’ll have to apply and qualify for another loan.

Or if you only borrowed part of the approved loan amount initially, you usually can’t just draw more from the same loan later. Be conservative when estimating the loan amount you need.

4. Lengthy Repayment Terms

Personal loans typically take between 1-7 years to repay. Shorter terms mean higher payments but less total interest paid. Longer terms have lower payments but increase total interest costs.

Committing to years of installment loan payments reduces financial flexibility compared to short-term options like credit cards or buy now, pay later financing. Make sure you can manage the monthly payments long-term.

5. Loan Qualification Challenging with Bad Credit

Having bad credit scores below 630 makes it much harder to qualify for a personal loan, and leads to higher rates when approved. Lenders view bad credit applicants as riskier.

Weak credit borrowers can still get approved through alternative lenders, but should expect rates of 25% or higher. Improving credit first may enable qualifying for more reasonable rate offers.

6. Max Loan Amounts Have Limits

Most lenders cap maximum personal loan amounts at $35,000 or $50,000 for those with good credit. Higher incomes and scores can potentially qualify for up to around $100,000.

But amounts above that are hard to get approved for with personal loans. If you need to borrow more than $100,000, you may need to look into other options like business loans or home equity loans/lines.

7. Can’t Reborrow Paid Principal

Once you make principal payments, that part of the loan balance is gone for good. You can’t reborrow paid principal like you can with credit cards or lines of credit.

The fixed lump-sum nature of personal loans makes it important not to underestimate the amount needed. But at the same time, you don’t want to borrow more than necessary and overextend yourself.

8. Origination & Late Fees Can Add Costs

Many lenders charge origination fees of 1-6% of the total loan amount. These upfront fees cover processing costs to provide the loan. Late fees also add expenses if you happen to miss payments.

Always factor origination fees into the total costs. And setup autopay through the lender to avoid late fees for skipped payments. Paying on time avoids costly added fees.

9. Tax Deductibility Limitations

You can’t deduct personal loan interest on your taxes like you can with mortgage and student loan interest (subject to limits). The lack of tax deductibility eliminates a cost-saving benefit.

The non-deductible interest increases your after-tax cost of borrowing. Run the numbers to see if other financing options with tax deductible interest offer more savings.

10. High Payments With Short Terms

Opting for a faster 12-36 month repayment term minimizes interest costs but requires affordably higher monthly payments. Make sure your budget can handle larger payments before signing up for a short term.

Pre-qualify to see proposed payment amounts based on your desired loan amount and term options. Do the math to strike the right balance for your situation.

11. Risks of Borrowing Too Much

It’s tempting to want to borrow more than you may realistically be able to repay. This can stretch your budget too thin and make loan default more likely.

Lenders want you to borrow as much as possible to earn more interest. But it’s up to you to only borrow what is sensible for your income and expenses. Don’t let pre-approvals cloud your judgment.

Who Should (and Shouldn’t) Get a Personal Loan

Whether a personal loan is advisable for you depends on your individual circumstances and financial profile.

Below I’ll summarize some situations where personal loans typically make sense, as well as cases where other financing options may be better.

Good Situations for Personal Loans