You may have seen an Instagram ad, a Google banner or a piece of actual paper mail advertising a personal loan. Maybe the ad even claims that you’re “pre-approved.” You’re wondering if it’s right for your situation.
“Personal loans offer a lot of benefits to the right borrower, but as with any financial solution, they aren’t right for everyone,” said Shannah Compton Game, a CERTIFIED FINANCIAL PLANNER® professional and Haven Life contributor. So is one right for you? You can figure out the answer to that question by reviewing these tips about what a personal loan is, how it works and what to consider before you choose one.
Personal loans
Personal loans come in all sizes, but it’s not uncommon for people to take out personal loans in the low- to mid-five figures. Often, people consider personal loans to pay down or pay off credit card debt, but might also get a personal loan to pay for medical bills, home improvement projects or an unexpected expense.
You can apply for a personal loan at your bank or credit union, and there are also many lenders online. The loan will have an interest rate, similar to any loan, and a specific term for repayment.
Potential benefits of a personal loan
The benefit of a personal loan is an infusion of cash that you can use for the purpose of your choice. The terms are based on the strength of your application (credit score, payment history, and other factors). A personal loan may offer a lower interest rate than a credit card, and some people use a personal loan to pay down higher-interest debt. Another common use is debt consolidation. Taking one personal loan to pay off several debts means you have just one bill to pay each month instead of many.
As with any financial product, it’s important to read the fine print. “Consider the amount of debt you have, the interest rates associated with that debt, the fees associated with the personal loan, and what your plan is for using and repaying the personal loan,” Game said.
A personal loan can also be a great way to work on achieving a higher credit score, especially if you have “thin” credit (you don’t have any or many accounts in your credit file). Adding an installment loan to your credit file can help you build a payment history. Just be sure to pay on time.
Another way a personal loan could help your credit is by lowering your credit utilization. If you pay off your credit cards with an installment loan (and don’t charge the cards back up again), your utilization could drop way down, even possibly to zero, and is likely to result in a better credit score. Of course, many other factors go into your credit score, so there is no guarantee that moving your debt from credit cards to a personal loan will leave you with a higher score. But credit scores do have a strong tendency to be inversely proportional to debt utilization.
“If your plan is to pay off expensive credit card debt with a fixed monthly payment to lower your credit utilization rate, then it might make sense to explore a personal loan,” Game said. The biggest influencers on your credit score are your payment history and your credit utilization (your revolving debt balances compared to your credit limits), and the greatest weight is given to credit history from the most recent two years.
If all you do is stay away from credit card debt and set up automatic payments on your personal loan, your score could rise dramatically in a relatively short amount of time. In fact, some banks offer credit builder loans for this very purpose.
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Read morePotential downsides of a personal loan
The downside of a personal loan is that even if it’s for a noble purpose, you’re still adding debt to your life. Also, taking a personal loan to pay off credit card debt has an inherent risk — some people run the credit card balances right back up again or fail to use the personal loan for its intended purpose, leaving themselves financially worse off than before.
The interest rate on a personal loan is usually fixed (not variable like on most credit cards) for the loan term, and average rates on personal loans tend to be higher than average rates on mortgages and many car loans. Some applicants will be offered a rate that is very high, and possibly even higher than the rates on their credit cards. Advertised rates from popular lenders like SoFi® and Lending Club® tend to go up to about 36 percent.
A personal loan does appear on your credit report. If your lender reports that you’ve missed one or more payments, your credit score will suffer, which could make it hard to get access to other credit products when you need them, at least until your score improves. Note that some lenders do not report late payments until they are 30 or more days late, but might charge a late fee on the first day after the due date.
Should you use a personal loan to pay down debt?
Whether you should take a personal loan to pay down other debt depends on several factors.
The first thing to consider is how the debt was created in the first place. Was it an unexpected expense, like a medical bill, or was it created by living beyond your means? What can you do to ensure you won’t get into that situation again? You may need to come up with a budgeting plan or downshift your current cost of living.
That said, a personal loan can be an effective way to lower your overall cost of debt, reduce the number of monthly payments you have to make, and set a clear finish line for payoff. A credit card balance can drag out for decades. There is some comfort in knowing exactly when the debt will be paid off, and a personal loan might help you accomplish that.
You might also have other options available to you. For example, if you qualify, it might make sense to take advantage of a 0 percent balance transfer offer. Keep in mind that there is usually a fee associated with balance transfers.
If you have family members who can help, it may make sense to ask for a loan from them. If you do, treat it like a bank loan. Agree in writing on the terms. That shows that you respect and appreciate the loan and intend to pay it back.
If you are really struggling with credit card debt, you might want to consider entering into a debt management plan (DMP). In a DMP, a credit counselor works with your creditors and may be able to get your interest rates lowered and fees waived. You make a single monthly payment to the credit agency, which disburses the funds to your creditors. You usually need to give up credit cards while you’re enrolled in the plan, but it’s designed to get you out of debt within three to five years. If this option sounds like it might be a good fit, visit the National Foundation for Credit Counseling to find a credit counselor in your area.
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Read moreWhat to consider before taking on a personal loan
Explore your options. The personal loan space is a crowded one. Your bank or credit union, online banks, peer-to-peer lenders — you may qualify for many different options. So which one do you choose? The right one for you may not be the offer that landed in your mailbox, no matter how enticing the terms may sound. “Just remember, loan options are not all created equal, so get quotes from at least two different lenders to make a fair comparison before you commit,” Game said.
Shop and compare. When you shop, it’s a good idea to compare fees, interest rate, and other terms carefully. For example, is the interest fixed — meaning it stays the same rate for the length of the term — or variable, which means it may change? Is there a fee for paying the loan off early? What do customers have to say about the lender through online reviews?
Change your habits. If your pattern is to spend above your means, it may make sense to work with a debt counselor who can help you create a strategy that will help you avoid a repeat of the same situation in the future. Depending on your income, you may pay a fee for credit counseling, but for many consumers the service is free. For those who pay a fee, it is typically $20 to $40 per month, and you can meet with your counselor in person, by phone or online.
Save up first. “If you’re dreaming of taking a tropical vacation with the funds, it’s probably best to skip the loan and not rack up more debt,” Game said. In other words, if you’re considering a personal loan for a major expense, like a wedding or a trip, ask yourself if your vision is really worth payments for three, four, five or more years. Taking on debt can be risky, so it may be a better option to modify your plans or make a commitment to saving now so you can afford the expense outright later.
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Anna Davies is a writer, editor and content strategist living in Jersey City, NJ. She has written for New York, Glamour, Elle, Men’s Health and others and has written 13 young adult novels under various names. Her favorite things to spend money on are discount theater tickets, oversize sweaters, and cold brew lattes.
Haven Life Insurance Agency offers this as educational information only. Haven Life does not endorse the companies, products, services and/or strategies discussed here.
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