When Are Personal Loans a Good Idea?
When Are Personal Loans a Good Idea?
Financial gurus will tell you to avoid personal loans. They’re
generally right, but sometimes one makes sense. First, let’s define a
personal loan. Some loans are earmarked for a specific purchase. You buy
a home with a mortgage loan, you purchase a car with an auto loan and you pay for college with a student loan.
But a personal loan can be used for just about anything. Some lenders
want to know what you will do with the money they lend you, but as long
as you’ve borrowed it for a responsible and legal reason, you can do
what you want with it.
That presents a problem. With a mortgage, your home is the collateral.
Similarly, with an auto loan, the car you buy is the collateral.
Because a personal loan often has no collateral – it is “unsecured” –
the interest rate will probably be higher. There are also secured
personal loans if you want to lower your costs.
Here are five circumstances in which a personal loan might be a good idea.
1. Consolidate Credit Cards
If you have one or more credit cards
that are charged to the max, you could get a personal loan to
consolidate all the charges into one monthly payment. What makes this
scenario even more appealing: The interest rate on the loan could be
considerably lower than the annual percentage rates (APRs) on your credit cards. (See Debt Consolidation Made Easy for more details.)
2. Refinance Student Loans
Consider this type of loan carefully before deciding whether or not
to move forward. Your student loan interest rate may be 6.8% or higher, depending
on the type of loan you have. But you might be able to get a personal
loan with a lower interest rate that allows you to pay off your loan(s)
faster.
Here are the issues: Student loans come with tax advantages. Also, if
lawmakers were to offer any loan forgiveness programs in the future, in
addition to those in place now, your refinanced student loans would not
be eligible.
If you use a personal loan to pay off all or
a portion of a student loan, you will lose the ability to deduct your
interest payments (when you file your income taxes) along with the
benefits that come with some loans, such as forbearance
and deferment. And if your balance is sizable, a personal loan probably
won’t cover it anyway. For additional information, check out Student Loan Debt: Is Consolidation the Answer?
3. Finance a Purchase
If your purchase is more of a want than a need, this is another
decision to weigh carefully. If you’re going to take out a loan anyway,
getting a personal loan and paying the seller in cash might be a better
deal than financing through the seller. Don’t ever make a decision about
financing on the spot, though. Ask the seller for an offer and compare
it to what you could get through a personal loan. Then you can decide
which is the right choice. For one example, see Personal Loans vs. Car Loans: How They Differ.
4. Pay for a Wedding
Any large event – such as a wedding – qualifies, if you would end up
putting all associated charges on your credit card without being able to
pay them off within a month. A personal loan for a large expense like
this might save you a considerable amount on interest charges, provided
it has a lower rate than your credit card.
5. Improve Your Credit
A personal loan might help your credit score in two ways. First, if
your credit report shows mostly credit card debt, a personal loan might
help your “account mix.” Having different types of loans is often
favorable to your score.
Second, it may lower your credit utilization ratio – the amount of total credit you’re using compared to your credit limit.
The lower the amount of your total credit you use, the better your
score. Having a personal loan increases the total amount you have
available to use. For other advice on boosting your credit score, see 3 Easy Ways to Improve Your Credit Score.
The Bottom Line
From a purely financial perspective, relatively small loans are
rarely a good idea. Most people can’t afford to pay cash for a home,
making a mortgage loan a necessity. But if you can avoid a personal
loan, or any other loan that is relatively small, you should. Instead,
save your money and purchase that “want” later. Remember, interest adds
up fast, and you may end up borrowing money for something that is worth
less than the value of the loan. Pay cash whenever possible.
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