Pros And Cons Of Personal Loans: Should You Get One?

Personal loans are a great tool to help you streamline your budget or get quick access to money in an emergency. From debt consolidation to paying for car repairs, you can usually get financing with a good credit score and a steady income. Many lenders also offer same-day loans, so you can get funds quickly. Average interest rates are also usually lower than other types of debt, like credit cards, which could save you hundreds, or even thousands, of dollars in interest.

But like all financial products, personal loans have their drawbacks. Some lenders charge high fees, and short repayment terms can mean higher monthly payments. Before taking out a personal loan, it’s worth weighing the pros and cons to determine whether a personal loan is the right financing option for you.

Pros and Cons of Personal Loans

Strong Points

• Payment is in one lump sum. The loan amount will be received in full at once.
• Funding time is fast. Loan funds may be available the same day you apply.
• No collateral is required. You don’t need to put up any equity in your car or home to qualify.
• Interest rates are low. You will usually pay a lower interest rate than with a credit card.
• Flexibility and versatility. The funds can be used for a variety of purposes.
• Fixed rates and payment schedules. You will receive a fixed payment with a clearly defined end date.
• Your credit score may improve. Replacing revolving credit card debt with fixed personal loan debt could improve your score.

Cons

• Interest rates may be higher than other options. Bad credit rates can be over 36 percent.
• There is no flexibility in payments. There is no minimum payment requirement like with credit cards.
• Fees and penalties can be significant. Fees of 10 percent or more may be deducted from the loan funds.
• The repayment period is shorter than other options. Most lenders offer repayment terms of up to five years, which can mean payments are significantly higher than with a mortgage.
• Increasing debt burden. High personal loan payments can make it difficult to get other loans.
• Once repaid, the credit cannot be used again. Because personal loans are installment loans, you can’t reuse your credit as you pay it off, like you can with credit cards and other revolving lines of credit.
• It could damage your credibility. Lenders will run a hard credit check to finalize the terms of your loan, temporarily lowering your credit score.

Benefits of a personal loan

Below are the advantages of using a personal loan over other types of loans: Knowing these advantages can help you decide if this type of financing is the best choice for your borrowing needs.

One-time payment

Borrowing the entire amount up front makes it easier to finance everything from major home improvement projects to major life events like weddings. Repayments are made in fixed-rate installments, meaning your monthly payments stay constant and predictable over the life of your loan.

This makes it much more stable than credit card interest rates, which can often fluctuate, and because you can’t reuse your credit when paying it off, there’s no risk of carrying a balance like with a credit card.

Rapid Funding

Many personal loan companies offer fast approval and funding timelines, with funds usually available within one business day. This can be useful in emergencies or situations where you need money quickly. If you qualify, some lenders can deposit loan funds into your bank account the same day you apply.

No collateral required

Personal loans are unsecured, meaning you don’t need any collateral like a car or a home to get approved. If you can’t repay the loan, it could damage your credit score, but because they’re unsecured, you don’t risk losing your transportation or home through repossession or foreclosure by the bank.

Lenders typically approve loans based on proof of stable employment, regular income, and a credit score. The loan process is often quicker than secured loans because lenders do not need to assess the value of collateral to lend.

Low interest rates

Personal loan interest rates are often lower than credit cards. As of September 2024, the average interest rate for a personal loan is 12.42%, while the average interest rate for a credit card is 20.78%.

Borrowers with good credit scores can qualify for personal loan interest rates that average around 10.73 percent to 12.50 percent, and may even qualify for loan amounts higher than their credit card limits.

Flexibility and versatility

Personal loans can be used for a variety of purposes, including paying for home improvements, purchasing expensive vehicles like boats or recreational vehicles, or consolidating multiple debts into one easy-to-track payment.

Although an auto loan can only be used to purchase a car, the loan is not limited to any specific use. Some lenders offer loan amounts up to $100,000, which allows you to borrow much more than most credit card companies will allow.

Fixed interest rates and payment schedules

Unlike credit cards, you know exactly how much you’ll pay each month, what interest rate you’ll pay, and how many months or years it will take to pay off. With a fixed rate, your interest rate remains constant, reducing the stress you feel when carrying a variable rate credit card balance.

You can extend the repayment term of your loan up to seven years, giving you more room in your budget. However, most personal loans allow you to pay off your balance early without penalty if you want. Remember: the longer the loan term, the more interest you’ll pay over the life of the loan.

It could boost your credit score

Many people take out personal loans to consolidate their debt, especially revolving debt like credit cards. The reason is simple: paying off credit cards is highly effective at improving your credit utilization ratio, which has a big impact on whether you have a high or low credit score.

You can also reduce the risk of falling behind on payments by replacing multiple variable rate credit card payments each month with one fixed rate personal loan payment.

Disadvantages of personal loans

Personal loans aren’t the right financial vehicle for every situation, so understand the drawbacks so you don’t get stuck with regular fixed payments that your budget can’t accommodate.

Interest rates can be higher than with a home equity loan

If you own a home, you may want to compare home equity loans or home equity lines of credit (HELOCs), especially if you have a fair or good credit score. This is especially true for borrowers with poor credit, who may be subject to interest rates of over 30 percent, higher than many credit cards.

No payment flexibility

You choose the loan amount and repayment term, and those payments are fixed until the end of the repayment term. If your payments vary (tip income or self-employed), you might want to stick with a credit card because payments are based only on what you use and there is the option for minimum payments.

If you don’t need the full amount all at once, consider a personal line of credit or home equity line of credit. You can use the funds when you need them, pay off the balance, and re-use the line of credit as needed.

Fees and penalties can be significant

Personal loan lenders’ fees range from 1 percent to 12 percent of the loan amount, and this fee is usually deducted from the amount paid to the borrower.

Although rare, some lenders charge prepayment penalties if you pay off the balance before the end of the loan term. Be sure to find out all of the fees and penalties of any personal loan you’re considering before you apply.

Shorter repayment terms than other options

One drawback of a personal loan vs. a home equity loan is that the repayment term is typically limited to 7 years. With a home equity loan, HELOC, or cash-out refinance, you can choose a repayment term of up to 30 years, resulting in a much lower monthly payment.

There are also tax benefits to taking out a home equity loan rather than a personal loan if the funds will be used solely for home upgrades and renovations. Mortgage interest used for renovations may be tax deductible, but this is not the case if you take out a personal loan to renovate your home.

Increasing debt

Many lenders set the maximum payment term at five years, which can result in monthly payments that significantly increase your debt-to-income ratio (DTI). Lenders measure your DTI ratio by dividing your total debt by your pre-tax income. A high DTI ratio could make it harder to borrow money in the future.

Repeatedly using personal loans to consolidate credit card debt can indicate that you are relying too much on credit cards. If you are not careful, you may be tempted to get into more debt after paying off your debt with a debt consolidation loan, instead of focusing solely on paying off your debt.

Taking out a personal loan can help you consolidate high-interest debt, but it can also put you in even more debt if you don’t address bad financial habits like not budgeting, not saving enough, or making impulse purchases.

Credits that have been repaid cannot be reused

With a personal loan, you receive the full amount at once and must repay the entire balance. With a credit card, you can use the approved credit as much as you want and reuse it in the future.

Even if you don’t need the full amount of a personal loan right away, you start paying off the entire balance right away. Credit card payments, on the other hand, are based only on the bill amount, not your entire credit limit.

Possibility of damage to credibility

When you apply for a loan, the lender will run a hard credit check, which will drop your score by a few points. However, the initial drop won’t last long, and the short-term drop from the check will likely be offset by a lower credit utilization ratio, especially if you’re paying off credit card debt.

Remember: The amount of revolving debt you owe accounts for 30 percent of your FICO score, so consolidating your debt and curbing future credit card use could significantly boost your score.

Should I take out a personal loan?

A personal loan can be an attractive option, especially if you need cash quickly.

When a Personal Loan is Right for You

Once you’ve researched the options and potential interest rates available to you, here’s how to determine if a personal loan is right for your situation.

• If you have a high credit score: The lowest interest rates are only available to borrowers with good credit.
• You have a steady salary: A personal loan only makes sense if you have a regular salary and enough income to comfortably make payments for the period you choose.
• If you want to pay off high-interest debt: A personal loan is a good way to consolidate and pay off expensive credit card debt.
• The funds are used for necessary expenses. Other reasons for using a personal loan include paying emergency expenses or making home improvements.

Time to look for alternatives

A personal loan is one of many ways to get cash, and depending on your situation, a personal loan alternative may be a better fit.

1. You have a tendency to spend too much: Taking out a personal loan to pay off your credit cards may not make sense if you’ll soon start racking up new credit card balances.
2. If you can’t make monthly payments: Consider the repayment schedule and monthly payments of your personal loan. Use a loan calculator to determine if you can afford the monthly payments over the repayment term.
3. Money is not urgently needed: It may be wise to build up savings for a big purchase rather than taking out a personal loan and paying it back with interest for years.
4. Unstable income or employment situation: If your salary or employment is unstable, it doesn’t make sense to continue making regular monthly payments for the next two to seven years. Seasonal workers, contract workers, and self-employed consumers may be better off taking advantage of the flexibility of a credit card or line of credit.

Conclusion

Personal loans have many benefits for borrowers who need money quickly and want a fixed interest rate and the security of payments for the term of the loan. If you have too much credit card debt or want to avoid borrowing against an asset, such as your home, a personal loan may be a good “clearing” tool.

But the costs can be higher if you have poor credit, and if your income is unpredictable, it can quickly become a financial burden.

If you decide a personal loan is right for you, be sure to compare interest rates and loan terms. Read the fine print, including fees and penalties, and decide if the benefits of taking out a personal loan outweigh the drawbacks before you commit.