The Pros and Cons of Personal Loans

The Pros and Cons of Personal Loans

The Pros and Cons of Personal Loans
Reading Time: 5 mins

The benefits of personal loans often make them a better financing option than other types of loans. Although some loans can be used only for a particular purpose, personal loans can be used for a variety of purposes, including to pay medical bills and consolidate debt. If you want to make a purchase without being restricted in how you spend the money, a personal loan is often your best alternative.

The Benefits of Personal Loans

Personal loans have interest rates that are lower than those of many other kinds of loans. In February 2021, the average rate on personal loans was 11.84 percent, whereas the average credit card rate was 16.04 percent. If you have an excellent credit history, you can qualify for personal loan rates ranging from 6 percent to 8 percent. You can also borrow a larger amount this way than you can through credit cards.

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If you are obtaining an unsecured personal loan, you do not need to provide collateral in order to be approved. So you don’t have to worry about guaranteeing the loan with assets like your car or your home. The single monthly payment schedule of a fixed-rate personal loan also makes it easy to manage.

What Is a Personal Loan?

Also called a long-term financing plan, a consumer loan, or an installment loan, a personal loan allows you to borrow a certain amount of money that you agree to pay back over a certain period of time.

There are two types: secured and unsecured. To obtain a secured personal loan, you use an asset like your car as collateral; if you fail to pay the loan, the asset is confiscated. An unsecured loan does not require collateral. But the lender has other ways to compel repayment if you default, including a lawsuit.

You must repay the full loan amount in installments along with interest and any other applicable fees. Typically, personal loans are used to purchase assets like furniture, to finance a home renovation, or to consolidate debt with higher interest rates. In Canada, most personal loans are between $100 and $50,000 and have a repayment period of six months to sixty months.

When Is It a Good Idea to Take Out a Personal Loan?

A personal loan is not always a good idea, especially if you have cheaper alternatives. But it’s a good idea if your lender is reputable, you have good reasons for seeking the loan, and you are able to pay it back. Valid reasons include a desire to achieve a particular financial goal such as renovating your home to boost its value or consolidating costlier debt.

You have a good reason to take out a personal loan if you want to:

1. Improve your credit score.

Although a personal loan may hurt your credit score in the short term, the long-term benefits are substantial. Personal loans boost your credit score for as long as you make your payments on time.

2. Pay for expenses with a lower interest rate.

You may need a personal loan to pay for expenses like home improvements, medical expenses, emergency needs, and weddings. Fixed monthly installments spread out over a long period are in most cases easier to budget for and less of a financial burden than making payments on a credit-card loan with a high interest rate.

3. Consolidate debt.

Using a personal loan to pay off existing debt will decrease the number of payments you need to make per month and will probably lower the interest rate you pay on the debt.

In Canada, some companies offer personal loans to people seeking to pay off credit-card debt. The rates on these loans are usually lower than credit-card rates. The loan may be a good way to clear your credit card balances and pay them off over a longer period of time.

When Is It a Bad Idea to Take Out a Personal Loan?

If the loan you’re seeking has a very high interest rate and your means of payment is unsteady, you should reconsider applying for it; it will probably do more harm than good. Particularly, avoid a personal loan when the lender does not require a credit check; cheaper alternatives are available.

It’s not a good idea to take out a personal loan if:

1. You’re just going deeper into debt thereby or you lack the discipline to manage debt.

Debt has a way of encouraging you to spend more than you can afford, especially if you allow yourself to feel as if you are getting something for nothing. But you will eventually have to repay the debt. The higher the interest rate, the more you will have to repay and the longer it will take. Debt borrows from your future income, making it impossible for you to get value from your money. It also prevents you from achieving your financial goals, hurts your credit score, and causes stress that can lead to serious health problems. Get a personal loan only if you must. Avoid it if you have debt-free or cheaper options.

2. The bank won’t lend to you at a favorable rate.

Taking a personal loan at a higher interest rate than you can afford leads to financial stress. The interest rate also affects the amount you can borrow. The higher the interest rate, the lower the amount.

How to Obtain a Personal Loan

You can secure a personal loan from traditional lenders like banks and credit unions. You can also try title loan companies, pawnshops, payday lenders, and private lenders. Lenders generally require that you have a regular income, a bank account, and a permanent address before they consider lending to you.

Before providing a loan, prospective lenders will run a credit check. Your credit report and credit score enable them to evaluate your ability to repay and affect your options, including the interest rate and the type of loan you qualify for. Make sure that you are able to repay the loan even if your lender is willing to give you more than you need.

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To apply for a personal loan, you need:

  •  Personal identification, such as a Social Security card, driver’s license, or passport.
  •  Proof of income, such as W-2s, copies of filed tax returns, and pay stubs.
  •  Employer information.
  •  Proof of residence.

To apply for the loan, follow these eight steps:

  1. Crunch the numbers to determine how much money you need and whether you have the ability to repay the loan.
  2. Check your credit score. The better your credit score, the better your chances of being approved.
  3. Consider all your options. If you do not qualify for the loan on your own, you may win approval if someone with good financial health is willing to cosign the loan.
  4. Choose your loan type. Apply to a lender who will loan you money for the reason that you need it.
  5. Shop around for the best interest rates.
  6. Choose a lender and apply for the loan.
  7. Provide all required documents.
  8. Accept a loan offer.

When you accept a personal loan, the lender may give you the money in the form of a check or an electronic deposit to your bank account or prepaid card. The lender may also send the money directly to other lenders if you are consolidating debt. Often, repayment is made by pre-authorized debits; having obtained your banking information, the lender takes the payments directly out of your account.

Conclusion

Personal loans have several benefits. But before getting one, make sure that you have a proper plan for using the money and know how you will make your payments, which include interest and other fees. Also consider the pros and cons of personal loans in comparison to other financing options, like home equity loans or credit card balance transfers. Obtain quotes from several lenders and compare interest rates and loan terms. Take the time to read the fine print, especially to be aware of all relevant fees and penalties. Once you have gathered the information you need, make your decision on the basis of the benefits of the loan—then consult a financial advisor for guidance about the best personal loans available.

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