Personal Loans Pros and ConsPersonal Loans
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Because interest rates are so low right now, many people are considering taking out personal loans. But is this a good choice? I can’t answer that question for you since I don’t know your specific situation. Instead, I’m going to discuss some of the pros and cons you should consider before deciding to take out- or not take out- a personal loan.
In this discussion, I’m not using the term “personal loan” to refer to payday loans or cash advance loans, which I consider scams, not loans. Instead, when I use the phrase “personal loan”, I’m talking about a loan from a reputable lender that is directly deposited in your bank account and on which you make fixed monthly payments of principal with a small amount of interest.
If, after hearing the pros and cons of personal loans, you’re interested in withdrawing one yourself, you may want to check out Fiona, a free, reputable lender that compares interest rates and terms at personal loan lenders and matches you with one that best fits your situation.
Personal Loan Pros
Pro #1: Credit Score Increase
By taking out a personal loan, you can actually increase your credit score in three ways:
- Improved Payment History: Timely payments made on your personal loan will positively impact your payment history, which accounts for 35% of your credit score.
- Decreased Credit Utilization: Personal loans can also increase your credit score if you use your proceeds to pay off higher-interest credit card debt. For example, if you have a single credit card with a credit limit of $5,000 and a balance of $4,000 (equal to 80% credit card utilization) but are approved for a $3,000 personal loan, you can use that $3,000 to pay off part of your credit card balance, lowering your credit card utilization to just 20%. Because credit card utilization accounts for about 30% of your credit score, using low-interest loans to pay off credit cards in this manner can dramatically improve your credit score.
- Enhanced Credit Mix: Finally, if you only have revolving credit such as a credit card, a personal loan may increase your credit score by increasing your credit mix, which accounts for 10% of your credit score.
Pro #2: Opportunity to Consolidate Debt
You can actually save money by withdrawing a personal loan to pay off higher-interest debt. For example, if you take out a personal loan at 10% interest and use it to pay off a credit card at 20% interest, you’ll end up effectively paying 50% less interest than you otherwise would have.
Pro #3: Avoid High-Interest Credit Card Use
In some cases, a personal loan can keep you from incurring higher-interest debt. As you know if you’ve taken my personal finance course, I strongly recommend maintaining an emergency fund to account for any unforeseen expenditures. However, if you don’t have an emergency fund and need to make a sudden payment, a low-interest personal loan can provide a much cheaper option than a high-interest credit card.
Pro #4: Can Invest the Proceeds to Make More Money
If you borrow money at a low interest rate and use it to invest in something with a high interest rate, a personal loan can actually make you money. I usually compare this to a mortgage on a rental property- you borrowed money and you’re paying interest, but you’re making rental income that more than covers those interest payments.
While this is a benefit of personal loans that I myself have used in the past, bear in mind that this strategy carries significant risk; there’s always risk in investing, but that risk is amplified when you borrow money to invest.
Personal Loan Cons
Con #1: Can Hurt Your Credit Score
While taking out a personal loan can increase your credit score, it can also harm your credit score in several ways.
- Credit Pull: First, your lender will likely pull your credit when you apply, which can temporarily take a few points off your credit score.
- Decreased Length of Credit History: Second, a personal loan can decrease your length of credit history, which accounts for about 15% of your credit score. Because length of credit history is calculated by averaging the amount of time you’ve had items on your credit report, adding a new personal loan can dramatically reduce your length of credit history, thus negatively affecting your credit score.
- Flawed Payment History: Finally, as I mentioned earlier, payment history accounts for 35% of your credit score, so if you repeatedly miss payments on your personal loan, you may see a significant drop in your credit score.
Con #2: Can Give You License to Spend
A personal loan can cause you to spend irresponsibly. Normally, people are less reckless with their spending when they have very little money- that’s why I keep very little money in my checking account. If you suddenly see a large amount of money sitting in your account, though, you may be tempted to spend in ways you otherwise wouldn’t.
Con #3: Interest Payments
Personal loans come with interest that comes out of your pocket.
Con #4: Possible Fees
Many personal loan products charge additional fees, including non-refundable application fees, origination fees, prepayment penalties, and late payment fees. Therefore, before applying for a personal loan product, you should always ask the lender about all possible fees.
Should You Get a Personal Loan?
I can’t decide whether a personal loan is a good fit for you. You yourself have to weigh the pros and cons and decide if the interest you pay on a loan is worth it.
If you’re going to use your loan to pay off higher-interest credit card debt, a personal loan may be a good option as long as you make timely payments and don’t wreck your credit score.
On the other hand, if you’re just looking for money to spend on a vacation or similar expense, taking out a personal loan is probably not a good option. When it comes to consumption, I’m a big fan of delayed gratification; not only is using non-borrowed funds a smarter financial decision, but whatever you buy will also be much more satisfying if you worked hard for it and paid for it with your own money.
If you do decide to get a personal loan, make sure you understand all terms, conditions, and fees, since many personal lenders advertise low interest rates but then charge enormous fees.
Logan is a practicing CPA, Certified Student Loan Professional, and founder of Money Done Right, which he launched in 2017. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.