The Lopez family was excited about finally getting to remodel their kitchen, something they’d been wanting to do for over a year. However, their excitement transformed into anxiety when their contractor told them the bills for the project would come to around $20,000. They knew they could charge it all on their credit card, but the most they could possibly squeeze out of their budget to pay it back would be $500 a month. At that rate, they’d take nearly six years to pay off the debt and pay more than $7,000 in interest.
The Lopezes were all set to scrap their plans for their dream kitchen when their contractor told them about another possible way to fund the remodel: a personal loan. With their good credit, they could get a five-year loan at an interest rate of around 7% – half of what they’d have to pay on their credit card. Not only could they pay it off faster, their monthly payments would be just under $400, leaving them with a lot more wiggle room in their budget.
Personal loans aren’t nearly as common a way to borrow money as credit cards. According to the Federal Reserve, only 10% of Americans applied for a personal loan in 2016, while roughly 65% applied for credit cards. However, their popularity is growing. TransUnion reports that personal loans in the United States grew by double-digit rates every year between 2014 and 2017, reaching an all-time high of $107 billion by the middle of 2017.
What Is a Personal Loan?
The type of borrowing most people know best is credit cards, which are a form of revolving debt. They give you access to a pool of cash that you can dip into as needed. You can take as long as you like to pay off this debt, as long as you meet the minimum payment each month, and the interest rate is likely to vary over time.
Personal loans are completely different. They’re a type of installment loan, in which you borrow money from a bank or other lender and pay it back in regular monthly payments over a fixed period of time. The term for most personal loans is between two and five years, but it can be as little as one year or as long as seven. The interest rate is usually fixed over the entire life of the loan.
There are two main types of personal loans:
- Secured Personal Loans. With a secured loan, you offer the bank something of value as collateral, such as your house, car, or the cash in a CD or savings account. If you’re unable to make your payments, the bank can seize your collateral to pay off the loan.
- Unsecured Personal Loans. Most personal loans are unsecured – not backed by any sort of collateral. Instead, the bank looks at your financial history to decide whether you qualify for the loan. Because these loans are riskier for the bank, they tend to come with higher interest rates.
Examples of Personal Loans
People take out personal loans for a variety of reasons. The most popular ones include:
- Debt Consolidation. When you use a personal loan for debt consolidation, you borrow one large sum of money and use it to pay off all your other debts, such as credit cards, student loans, and auto loans. Debt consolidation can make managing your finances easier because you only have one monthly payment to keep track of, instead of multiple payments to different creditors. It can also save you money if the debt consolidation loan has a lower interest rate than the other debts you started with.
- Unexpected Expenses. Major, unplanned expenses, such as hefty medical bills or major car repairs, can completely derail your finances. The best way to handle crises like these is to have an emergency fund to cover the cost. However, if you don’t have one, or if you’ve already exhausted it, a personal loan can be a good way to turn a massive one-time expense into a series of manageable payments.
- Home Improvements. Home renovations can be expensive. According to Home Advisor, it costs an average of $9,634 to remodel a bathroom, $22,011 to remodel a kitchen, and $42,070 to build an addition. Many homeowners don’t have that kind of cash on hand, so a personal loan can be a way to do the renovations right away and pay the bills over time.
- Wedding Costs. Weddings are another big, one-time expense. Although it’s certainly possible to plan a wedding on a budget, it’s not uncommon for American couples to spend $10,000 or more to host the wedding of their dreams. A personal loan can be a cheaper alternative for financing this big event than credit cards.
- Vacation Expenses. Some people even take out personal loans to pay for a dream vacation. Granted, it makes more sense to save up for a special vacation beforehand, but if you have a once-in-a-lifetime opportunity and don’t have the cash, a personal loan could be your next-best alternative.
Sources of Personal Loans
There are several places to apply for a personal loan. You can get this type of loan through traditional banks, credit unions, online lenders like Upstart, or peer-to-peer (P2P) lending networks like Prosper and Lending Club. Online and P2P lenders are convenient to use, but some of them aren’t available to borrowers in every state.
No matter what kind of lender you use, it will want to look at your finances before approving you a personal loan. The lender will pull your credit report and check out details like your credit history, credit score, and debt-to-income ratio. The better your credit is, the more likely you are to qualify for a loan, and the better the interest rate will be.
Advantages of Personal Loans
If you need to borrow money, there are several reasons why a personal loan might be a good choice. For instance:
- They Have Many Uses. Many types of loans, such as mortgages, auto loans, and student loans, can only be used for one specific purpose. A personal loan, by contrast, can be used for anything you like.
- You Don’t Need Collateral. Most personal loans don’t require any kind of collateral. This makes them a good choice for people who don’t have anything of value to borrow against.
- You Can Borrow Any Amount. Typical amounts for a personal loan range from $1,500 to $100,000. That means you can borrow a lot more with this type of loan than you could with a credit card, yet you can also use one if you only need a relatively small amount.
- Rates Are Reasonable. Personal loans are often cheaper than credit card borrowing. For a borrower with a good credit score, interest rates for this type of loan can be as low as 5% APR, according to this article from Credit Karma. By contrast, credit cards usually charge at least 13% APR, even for the most creditworthy customers.
- You Don’t Need Great Credit. It’s possible to qualify for a personal loan even if your credit is poor. Some lenders are willing to offer personal loans to customers with credit scores of 600 or even lower. These borrowers are likely to pay higher interest rates – as much as 36% APR. However, that’s still much less than the interest on a payday loan, which is one of the most common options for subprime borrowers.
- You Have Plenty of Time to Pay. Another big problem with payday loans is that you only get a couple of weeks to pay them off in full. Many cash-strapped borrowers can’t manage this, and so they end up rolling over the loan or taking out another one right away. Personal loans give you at least a year to pay off the debt, breaking it down into much smaller and more manageable monthly payments.
Disadvantages of Personal Loans
Despite their benefits, personal loans aren’t always the best way to borrow money. Here are a few of their drawbacks:
- Fixed Payments. When you borrow money with a credit card, you can take as long as you need to pay it back. A personal loan, by contrast, has fixed payments that must be made on time. If you don’t meet these payments, the lender can seize your collateral if it’s a secured loan or sue you for nonpayment if it’s an unsecured one.
- Higher Rates Than Some Loans. For borrowers with good credit, personal loans typically offer lower interest rates than credit cards. However, for those with poor credit, a personal loan could cost as much as a credit card loan or more. Personal loans, especially unsecured ones, can also cost more than other types of installment loans, such as home equity loans.
- Origination Fees. In addition to the interest, many personal loans come with an “origination fee” to cover the cost of processing the loan. This fee is typically between 1% and 6% of the amount borrowed. You must pay this full amount up front when you take out the loan, rather than paying it back over time as part of your monthly payment.
- Prepayment Penalties. When you borrow money with a credit card, you can avoid paying interest by simply paying off the full balance as soon as you can afford it. However, with a personal loan, that’s not always possible. Many banks charge you a prepayment penalty if you pay off your loan early so they can make up for the interest they’re missing out on.
- Potential for Scams. A final risk of taking out a personal loan is that not all loan offers are legitimate. Scammers sometimes offer fake personal loans applications in order to get hold of your personal information, which they use for to steal your identity. In some cases, they also charge you a fee up front to initiate the loan, then disappear with the money. This is known as an advance-fee scam.
Alternatives to a Personal Loan
Depending on your situation, a personal loan might not be the best way for you to borrow money. Before taking one out, check out these alternatives to see if one of them is a better deal for you:
- Balance Transfers. If you can qualify for a credit card with a zero-interest balance transfer offer, this is a much cheaper way to consolidate debt from other credit cards than a personal loan. If you transfer the debt to the new card and pay it off within the introductory period, you’ll pay no interest at all. Even if you can’t pay off the full amount that quickly, you could still pay less in total interest than you would making fixed payments on a personal loan for several years. If you want to consolidate debt, NerdWallet has a calculator you can use to estimate whether a balance transfer or a personal loan is likely to be a better deal for you.
- Credit Cards. If your credit isn’t that great, borrowing with a credit card could be cheaper than taking out a personal loan. To figure out which is better for you, check the interest rate on your credit card and use a credit card payoff calculator, such as the one at Bankrate, to figure out how long it will take to pay off your debt and how much you’ll pay in interest. Then check out the terms of a personal loan and figure out how much it will cost you in total, including interest and fees. Bankrate also has a personal loan calculator you can use for this purpose. Finally, compare the two numbers to see which loan is cheaper.
- Home Equity Loans. If you own your home, you can also borrow money with a home equity loan or home equity line of credit (HELOC). A home equity loan is an installment loan, while a HELOC is a type of revolving credit like a credit card. Home equity loans and HELOCs are a popular choice for home renovations. They often allow you to borrow larger amounts than personal loans, and the interest rates are sometimes lower. However, you’re putting up your house as collateral for the loan, so if you can’t pay, the lender could foreclose on your home.
Get a Good Deal on a Personal Loan
If you decide that a personal loan is the best way for you to borrow money, there are several steps you can take to make sure you get the best deal possible:
- Make Sure the Lender Is Legit. There are a few simple ways to sort out a real personal loan offer from a scam. First, make sure the lender is registered in your state. You can find this information on the lender’s website or by contacting your state attorney general’s office. Also, watch out for obvious red flags. If the lender’s website isn’t secure or doesn’t provide a street address, that’s a sign the business is fake. Other warning signs include a lender who doesn’t check your credit history, asks you to pay the origination fee with a prepaid debit card, or pressures you to apply today because it’s a limited-time offer.
- Compare Multiple Offers. Before taking out a personal loan, compare offers from multiple lenders. Most lenders will let you check out their estimated rates and fees before you actually apply. Don’t just look for the lowest APR; compare the total cost of the loan, including fees. To save time, consider visiting an online loan marketplace, such as NerdWallet’s, where you can compare loan offers from different lenders at a glance.
- Make Sure You Can Afford It. Remember, when you take out a personal loan, you’re committing to pay it back on time. If you fail to meet the payments, you could lose your collateral or end up in court. So, before you sign on the dotted line, check your personal budget and make sure you can afford to make the monthly payments.
- Keep It Short. Longer-term loans sometimes look more affordable than short-term ones. The monthly payments are lower because you’re spreading them out over a longer period, and the interest rates are usually lower as well. However, in most cases, the longer you spend making payments on your loan, the more you’ll pay in interest altogether. In the long run, you’re better off taking out the shortest-term loan you can manage the payments on.
- Pay It Off Promptly. If your loan does not have a prepayment penalty, you can save on interest by paying it off faster. You can make extra payments whenever you have some spare cash, or just tack a little extra on to every monthly payment. Also, check to see whether the lender is willing to offer you a small discount on the interest for enrolling in paperless billing or autopay.
Personal loans can be a convenient way to borrow money, but they’re not ideal for every situation. A zero-interest balance transfer is often a better deal for those with good credit, and straight-up credit card borrowing can be better for those with poor credit. The only way to know for sure is to do the math for yourself.
Have you ever taken out a personal loan? Would you recommend it?