Are Personal Loans Bad?
Reading time: 5 Minutes
October 4th, 2021
Are personal loans bad? The short answer is, "No."
There are some common misconceptions that personal loans come with high interest rates or are only for people with poor credit. However, personal loans can be powerful tools in your financial toolbox and help you achieve a wide variety of goals, such as buying a car, getting out of debt through debt consolidation, making a big purchase, and more.
What is a Personal Loan?
Personal loans are a type of installment loan. They offer borrowers fixed interest rates, defined repayment terms, and regular monthly payments—all of which can be useful to help you budget. Unlike a mortgage, which has a very specific use, personal loans can be used for a wide variety of purposes. Some of the most common are:
- Debt consolidation, allowing you to pay down high-interest debt with a lower-interest loan
- Buying a car, especially when buying used from an online seller, a friend or a family member.
- Major expenses that you don't have the saved-up cash to pay for right away, including home renovations, wedding expenses and travel.
The most common type of personal loan is an unsecured personal loan, which means that lenders will decide to loan you money based solely based on your ability to repay it, using criteria that includes your income level and your credit score. These kinds of loans are available through a wide variety of lenders, including banks and credit unions as well as various direct lenders.
Why is there Stigma about Personal Loans?
There are a few reasons people might say "yes" when you ask whether personal loans are bad. Some view any kind of debt as bad, and detrimental to your credit score, but in fact, when used correctly, debt can be a powerful tool that helps you accomplish your goals. This is why it's a good idea to look at personal loans in relation to your own overall financial situation to see if a loan makes sense for you.
Common Misconceptions about Personal Loans (and the Truth behind Them)
Personal Loan Interest Rates are High
In general, the interest rate for a personal loan is usually lower than what you can get on a credit card. This means that using a personal loan could help you save money in interest, compared with charging that same expense to your credit card.
It's true that interest rates for unsecured personal loans will often be higher than secured loans such as a mortgage or a car loan. That's because secured loans come with lower risk to your lender, since your home or car acts as collateral to guarantee the loan's repayment. But it also means you could lose your car or home if you ever stop making the required payments on the loan. Really the best financing comes down to your personal situation.
Personal Loans are Bad for your Credit Score
In fact, a personal loan can often have a positive effect on your credit score in the long run. It's true that, since lenders will require a credit check in order to approve a personal loan, your credit score might take a slight, temporary dip because of the inquiry.
But, if you're using the personal loan to consolidate debt, you might soon see your score rise as your credit card balances fall. This is because your credit utilization ratio—the amount of your total credit limit being used—is improving.
Also, since loans are viewed differently on your credit report than revolving debt such as credit cards, a personal loan can help diversify your credit, positively affecting your score.
Both of these factors can help improve your credit score, more than offsetting the impact of the inquiry on your credit report.
Personal Loans Just Add to your Debt
As we've mentioned, personal loans can be a great way to get out of debt, because they
- simplify your payments into one
- have lower interest rates than credit cards and payday loans so you pay more against principle
- don't change, making it easier to maximize your budget
When you take out a personal loan for debt consolidation, it's important to be responsible about paying down your credit cards and keeping the balances low. If you were to pay off your credit cards using the personal loan and then run them back up with additional un-budgeted purchases, you could very well find yourself in more debt than you began with.
Tip: Before applying for a loan to consolidate debt and save money on interest, come up with a solid budget that will help keep your credit card debt levels low over the long run.
How can a Personal Loan Help Your Finances?
Aside from the flexibility of a personal loan, taking out a loan can help improve your finances in several ways.
- Save more money. Because the interest rate on a personal loan will likely be lower than the rate on your credit cards, you could potentially save hundreds to thousands of dollars in interest costs.
- Pay off debt faster. When you use a personal loan to consolidate debt, the fixed payments and lower interest rates can help you speed your path to lower debt.
- Improve your credit score. As mentioned above, debt consolidation through a personal loan can diversify your credit mix and lower your credit utilization ratio—two important factors that affect your overall credit score.
- Create a predictable budget. The regular payments and set terms of personal loans can increase your financial peace of mind. You'll have a fixed amount to pay each month, as well as a specific date when your debt will be paid in full.
While only you can determine if a personal loan is a good fit for your financial needs, they're an incredibly versatile financial tool that can help you in several ways. There's no need to be afraid of a loan that can offer you fixed terms and payments. Take the next step by learning about what kind of personal loan might be best for your situation; you can even set up time to talk to an expert or apply right from the comfort of your couch.
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