Are personal loans bad?

Consequences of personal loans

There are many pros associated with personal loans, such as accessing funds at a lower interest rate than with a credit card and being able to use those funds for any purpose you may need. But there are downsides every borrower should consider.

For starters, taking on a personal loan means adding to your debt pool, increasing your total financial obligations. This could make it more challenging to manage all of your different debts.

Additional consequences associated with taking on personal loans include:

Origination fees are typically between 1% and 8% of your total loan.

• High interest payments. As of publishing, the average interest rate on a 24-month personal loan is 11.48%, according to the Federal Reserve Bank of St. Louis. However, rates can reach into the 20% or even 30% range if you have a low credit score, adding thousands to your total loan balance.
• Potential negative impact on your credit score. Applying for a personal loan results in a hard inquiry on your credit report. If you apply with multiple personal loan lenders at once, these hard pulls lower your score temporarily. Late or missed payments on the loan can further damage your credit.
• Your debt-to-income ratio goes up. Your debt-to-income ratio (DTI) is a measure of your monthly debt payments compared to your income. When you add a personal loan to your debt total, your DTI creeps up, potentially making it more difficult to qualify for other loans or credit in the future.
• High origination fees. Lenders charge origination fees to cover the cost of getting your loan prepared. Not all lenders have origination fees, but those that do typically charge between 1% and 8% of the total cost of the loan.
• Potential prepayment penalties. Along with origination fees, some personal loan lenders have prepayment penalties. This means you must pay an extra fee if you want to pay your loan off earlier.
• You could lose some collateral. Secured personal loans — meant for those with lower credit scores — require an asset like your car, home or investments to back up the loan. If you're using a secured personal loan and can't repay, the lender could seize your collateral to pay back the loan.

When should I get a personal loan?

When the time is right and you fit the financial criteria, getting a personal loan is extremely easy. But how do you know if the time's right and if you’re the right candidate?

“Personal loans are a stellar choice for tangible, long-term gains — say, turning your basement into a home office or consolidating ballooning credit card debt. But jetting off to the Maldives for a vacation? Not the best candidate,” said Tim Doman, an investment analyst and CEO of Top Mobile Banks, a website focusing on digital banking.

“I've seen clients who've regretted financing their dream holidays or opulent weddings through personal loans. When the holiday tan fades, they're left grappling with an obligation that, in retrospect, wasn’t quite worth it.”

While a fancy vacation may not be a good reason, personal loans may be the right option when:

• You have good to excellent credit. Interest rates on personal loans are often higher than other loan types, but that’s the price you pay for how easy the process is. If you have a good or excellent credit score, you qualify for much lower rates and potentially longer terms.
• You can pay back the loan in five years or less. Many personal loans max out at five-year repayment terms, making them best for shorter-term expenses. These short loan terms mean potentially higher monthly payments depending on how big of a loan you’re taking out, so make sure these payments fit into your budget comfortably.
• You want to pay down high-interest debt. One of the best uses for personal loans is to get yourself out of debt with higher interest rates. If you can consolidate your debt (typically credit card debt) into a personal loan with a lower interest rate, you’re not only paying less interest over time, but you now only have to manage a single monthly payment rather than multiple.
• You need help funding an emergency. Personal loans provide quick funding compared to other loan types, so if you’re in an emergency and need cash quickly, a personal loan can help. Some companies claim a one-day or same-day turnaround if you’re a strong financial candidate.
• You already have a purchase or expense in mind. While personal loans have a nearly endless list of uses, you shouldn’t get one just to have cash on hand. Only use a personal loan if you have a purpose that you couldn’t otherwise cover with savings.

» MORE: Should I get a personal loan?

When should I consider alternatives?

Despite how easy personal loans are to get for many borrowers, they’re not always the right solution. If you have a low credit score, you’ll only qualify for sky-high interest rates, if you qualify at all.

Additionally, if you’re planning a specific purchase, loans designed for that purpose may be more worthwhile. For example, auto loans often work better than personal loans for car purchases since they come in a variety of forms, typically with lower interest rates.

Weigh all your options before landing on a personal loan. Consider the many alternatives that may offer you better rates, terms and the amount you’re looking for.

Personal loan alternatives

Personal loans are a popular option, but they’re far from the only one. One of these options may work better for your financial situation:

• Personal savings: If you don’t want to pay any interest to finance a purchase, the best thing to do is make a savings goal and stick to it. Using your personal savings means you have complete control over your money and you don’t have to worry about repayment.
• Credit cards: For smaller purchases, credit cards offer an easy payment method that may even come with some rewards. Just make sure you can pay off the balance regularly, or else you risk racking up huge interest charges.
• Personal line of credit: Like a cross between a loan and a credit card, a line of credit gives you access to an amount of money that you can dip into as needed. You only pay interest on what you use, rather than the full value.
• HELOCs: Home equity lines of credit (HELOCs) also offer the flexibility of a credit card but instead use the equity you built up in your home to determine the credit line. HELOCs provide long repayment terms and large amounts compared to other loan options, but your house acts as collateral, so make sure you can afford payments.
• Home equity loans: Home equity loans are similar to HELOCs, but rather than a credit line, you’re given a lump sum loan. You can use this loan for home improvement projects and other purchases, and you’ll have a long repayment term, making home equity loans better for larger financing needs.

Bottom line

Personal loans have gained popularity quickly in the banking industry, offering an easy way to qualify for financing. And for those with good credit who have the room in their budget to manage a loan payment, it’s hard to go wrong with a personal loan.

However, for those who don’t fit that description, personal loans can be costly financing options with terms that are too short to manage.