When is taking out a personal loan a good idea and when is it not?
Whether taking out a personal loan is a good financial move or one that adds even more debt depends, at least in part, on why you want the loan. Good reasons, like reducing or paying off credit card debt , can help you improve your financial health. Other reasons, such as buying things you can’t afford, can increase your debt and ultimately hurt your credit.
Either way, a personal loan is neither easy money nor a quick fix. You should proceed carefully if you take out a personal loan, even for good reasons.
Good reasons to get a personal loan
People take out personal loans for a number of reasons. Deciding if taking out a personal loan is a good decision will depend on your situation and your financial habits.
The two most common reasons, according to a Credit Karma study of about 1.5 million Credit Karma members in the United States , were refinancing credit card debt and paying unexpected expenses. Other reasons mentioned were making a large purchase, making home improvements, and consolidating other debts.
And it’s not just low-income people who were seeking out personal loans for those reasons. Credit Karma’s survey revealed that 10% of members looking for personal loans to cover unexpected expenses had an annual income of $100,000 or more.
Whether the reason is good or bad depends in part on your financial situation and your opinion about taking on debt. A good reason would be if a loan can help you improve your financial situation.
“Using a personal loan to consolidate or pay off credit card debt can be a good idea if you have accounts that have high interest rates,” says Joe Toms, president and chief investment officer of FreedomPlus, a company that makes loans Personals in Tempe, Arizona.
Personal loans often have lower rates than credit cards and therefore can help you consolidate your credit card debt as well as help you pay less interest on your overall debt.
Reasons to think twice
If your reason for getting a personal loan isn’t a necessity, it doesn’t help you reduce your high-interest debt, or it only increases your total debt, you may want to reconsider your decision. Reasons you might want to think twice about taking out a personal loan may include paying for expenses you can’t afford, such as having a lavish wedding , plastic surgery, or an expensive vacation
“If you need a loan to go on vacation, that probably indicates you’re living outside your financial limits,” says Toms. “It’s not relaxing at all to go on vacation, go back to work, and be faced with a bunch of bills you can’t pay.”
Advantages of taking out a personal loan to pay off credit cards
In 2017, the average American had an average of $8,195 in combined credit card and retail card debt, Experian reported. In the first quarter of 2018, the average annual percentage rate was 13.63% on commercial bank credit cards.
If you carry a credit card balance from month to month, an APR of almost 14% can add up to a lot of interest. And keep in mind that this is just an average. APRs may be higher for people with low credit scores or poor credit history.
Compared to credit cards, a personal loan can offer three main advantages: a single monthly payment for consolidated debt, a fixed interest rate and fixed loan terms, says Rachel Kampersal, associate of programs and marketing communications for American Consumer. Credit Counseling, a nonprofit credit counseling agency.
a single payment
If you consolidate your debts through a personal loan, you may only have a single payment instead of having to deal with multiple payments. A single payment means you only have to remember a single payment date and a single amount to pay each month instead of paying on different dates and paying minimum amounts on several credit cards. This option could make it easier for you to manage your debt.
a fixed rate
Credit cards can have fixed or variable rates, but variable rate credit cards have recently become very popular. When you have a variable rate credit card, the interest rate changes in tandem with the prime rate, as published by the Wall Street Journal. That means your monthly payment and the amount of interest you pay on your balance may go up or down depending on your credit card agreement.
Many personal loans have a fixed rate that doesn’t change based on an index. A fixed rate—and monthly payment—less than the various rates on your existing credit accounts can help you pay off your account faster.
Fixed loan term
Personal loans usually have a set term to repay the loan, while credit cards are a type of revolving credit, where you can determine how much you need to borrow and pay each month, as long as you make the minimum payment. . And if you only make the minimum payment each month, it may take longer to pay off your credit card.
Having fixed payment terms with set monthly payments can help you set a budget to pay off your debts.
Other important notes about personal loans
What else should I know about personal loans before getting one to consolidate debt? Here are some of the things you should know:
How much money can you ask for in a personal loan? Amounts vary by lender, but personal loans generally range from $1,500 to $100,000. The amount you can borrow depends in part on the strength of your credit profile and how confident your lender is that you will repay the loan.
With or without guarantee
Personal loans may or may not be secured . Secured loans require collateral such as a savings account that can be cashed out if you don’t repay the loan as agreed. Unsecured loans do not require collateral, but they do carry higher interest rates.
Interest rate ranges
Interest rates for personal loans generally range from 5% to 36%, depending on the lender and the creditworthiness of the borrower. To find out what rates you may qualify for and possibly save money on your loan, shop around and compare lenders.
Lenders may charge fees
Some lenders charge an origination fee for processing the loan (usually a percentage of the amount borrowed) or a prepayment penalty if you pay off the loan before the end of the loan term. Again, shopping around and comparing lenders can save you money, so be sure to ask about fees or surcharges.
Credit scores are important
Although personal loans may offer lower interest rates than credit cards, you may not qualify for low credit rates if you have poor credit. In general, the better your credit scores and history, the better chance you have of qualifying for a personal loan with a lower interest rate.
Apply for a personal loan to pay off credit cards
There are many types of lenders that offer personal loans. Other options may include banks and credit unions, as well as consumer finance companies, peer-to-peer lending, and online lenders .
The application process is quite clear. Most lenders check your credit reports and scores. But keep in mind that a hard credit check, also known as a credit inquiry, can lower your credit scores by a few points.
You may need to provide personal information, such as what your income is and who your employer is, to show that you have a fixed income to make your payments.
“It’s important to have a good payment history on previous loans, and employment or a steady income,” says Tia Sabawi, vice president of consumer lending at savings cooperative Xceed Financial Credit Union. “You also need to feel comfortable making your new payment and be able to show that you have the resources to make that payment. Don’t borrow more than you can afford to repay.”
proceed with caution
Despite all these advantages, taking out a personal loan can be risky if you don’t have a plan to make the payments. A personal loan is a debt. If you already have more debt than you can handle, exchanging one debt for another may help you for a while, but it won’t ultimately solve your problem.
Getting out of debt, too, is going to require you to assess the factors that contributed to getting you into the original debt.
For example, if you use a personal loan to pay off your credit cards, but continue to use the cards to keep up with spending, you’ll end up racking up a bunch of credit card bills. Or, if you use a personal loan to pay for emergency expenses, but don’t save for future emergencies, you’ll have to take out another loan the next time an emergency arises.
“It’s important to carefully consider how and when you’re going to use personal loans and not get into a cycle of continual use to pay off accumulated debt,” Sabawi says.
But there are steps you can take to work out the debt you have and avoid future debt. Consider opening an emergency fund and preparing a budget.
Creating a budget and addressing the habits that got you into debt in the first place is important to avoid falling into the same situation with a new loan,” says Kampersal.
Should you get a personal loan to pay off credit cards? That is a personal decision. Only you can know for sure if this type of loan makes sense in your situation. Even so, there are some guidelines that can help you decide.
If you are going to take out a loan to cover expenses, you may end up going deeper and deeper into debt. If you’re ready to use credit responsibly and want to pay off high-interest credit card amounts, a loan can help you get a fresh start and better manage your finances.
If you don’t already have good credit, it can be difficult to qualify for low rates on a personal loan, and you may want to take steps to improve your credit before shopping for a loan. If you still don’t feel confident, you may want to research and compare offers before deciding if taking out a personal loan is a good option for you.