A personal loan can be utilised for almost any purpose. Some lenders will inquire as to your intended use of the funds, while others will just want to ensure that you have the financial means to repay it. While personal loans are not cheap, they can be a feasible alternative in a variety of situations. Here’s how to determine which is best for you.
Personal Loans: How They Work
Certain types of loans are reserved for a certain purpose. A mortgage can be used to purchase a home, an auto loan can be used to purchase a car, and a student loan can be used to pay for college. With a mortgage, the collateral is your home. Similarly, with an auto loan, the collateral will be the vehicle you are purchasing.
However, a personal loan frequently does not require collateral. Due to the fact that it is secured by property that the lender may seize if you default on the loan, the lender is taking a greater risk and will almost certainly charge you a higher interest rate than it would on a mortgage or auto loan. Your interest rate is determined by a variety of criteria, including your credit score and debt-to-income ratio.
When Should You Consider Taking Out a Personal Loan?
Before you take out a personal loan, you should evaluate whether there are less expensive borrowing options available. Several legitimate reasons to choose a personal loan include the following:
Consider a personal loan as well if you require funding for a relatively short and well-defined period of time. Personal loans are typically between 12 and 60 months in length. 3 Thus, if you have a lump sum of money due in two years but insufficient cash flow in the interim, a two-year personal loan may be a viable option.
Consider the following five scenarios in which a personal loan might make sense.
1. Credit Card Debt Consolidation
If you have a large amount on one or more high-interest credit cards, taking out a personal loan to pay them off may save you money. For instance, as of this writing, the average credit card interest rate is 19.49 percent, while the average personal loan interest rate is 9.41 percent. 1 This difference should enable you to pay off your balance more quickly and pay less interest overall. Additionally, it is easier to manage and repay a single financial obligation than it is to manage many debt obligations.
However, a personal loan is not the only option available to you. Rather than that, if you qualify, you may be able to transfer your debt to a new credit card with a lower interest rate. Certain balance transfer offers to waive interest completely for a promotional term of six months or more.
2. Resolving Additional High-Interest Debts
While personal loans are more expensive than other forms of loans, they are not always the most expensive. If you have a payday loan, for example, the interest rate is likely to be much greater than on a personal loan from a bank. Similarly, if you have an older personal loan with a higher interest rate than you qualify for now, refinancing it may save you money. However, before you do, confirm that there is no prepayment penalty on the old loan and that there are no application or origination fees on the new one. These costs can occasionally be rather considerable.
3. Financing a Major Purchase or Home Improvement
If you’re replacing appliances, installing a new furnace, or making another large purchase, a personal loan may be less expensive than financing directly from the vendor or charging the item on a credit card. However, if you have any equity in your home, a home equity loan or line of credit may be even more affordable. Of course, those are both secured loans, which means you’ll be risking your home.
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4. Financing a Significant Life Event
As with any large purchase, financing an expensive event, such as a bar or bat mitzvah, a significant milestone anniversary party, or a wedding, maybe less expensive if you use a personal loan rather than a credit card. According to a 2021 poll conducted by Brides and Investopedia, one in every five couples in the United States will utilise loans or investments to help finance their wedding. As critical as these occasions are, you may wish to consider a slight reduction in spending if it means incurring debt for years to come. For the same reason, borrowing money to pay for a vacation may not be a good option, unless it’s a once-in-a-lifetime excursion.
If you complete all of your payments on time, a personal loan can help you enhance your credit score. Otherwise, your score will suffer.
5. Sustaining a Positive Credit Score
Taking out a personal loan and repaying it on time can help you improve your credit score, particularly if you have a history of missing payments on other loans. If the majority of your debt is on credit cards, obtaining a personal loan may also boost your “credit mix.” Having a variety of loans and demonstrating your ability to manage them appropriately is considered a benefit for your credit score.
Having said that, borrowing money you don’t require in order to improve your credit score is a risky approach. It is preferable to continue paying all of your other obligations on time while also attempting to maintain a low credit usage ratio (the amount of credit you are currently utilizing in relation to the amount available to you).
The Verdict
Personal loans might be advantageous in some circumstances. However, they are not inexpensive, and there are frequently better options. If you’re considering one, the personal loan calculator on Investopedia can help you determine the cost.
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