Pros and Cons of Personal Loans: What You Should Know Before You Borrow

Personal loans are lump-sum installment loans commonly used to fund emergency expenses or consolidate high-interest debts. They have their upsides, including flexible borrowing limits, fixed repayment schedules and potentially low annual percentage rates (APRs). However, before you apply, it’s important to understand the pros and cons of personal loans to help you decide if applying for one makes sense.

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Quick Take

• Personal loans are commonly used for debt consolidation, medical bills or other large purchases.

• Loan amounts typically range from $1,000 to $50,000, but amounts of $100,000 or more are possible.

• After approval, funding typically takes one to five days, but some lenders may deposit funds on the same day.

• Repayment terms often range from two to seven years.

• Rates can range from 6% to 36%, depending on credit and basic personal loan requirements like income and debt levels.

What Are the Pros and Cons of Personal Loans?

There are many types of personal loans and they all offer fixed payments and flexible use. However, they only make sense if you can qualify for a competitive rate and commit to a consistent repayment plan.

When Is a Personal Loan a Good Idea?

Personal loans can benefit your financial situation in the following scenarios.

Debt Consolidation

Outstanding credit card balances are notoriously pricey. Plus, the ability to pay off and run up a balance again can create a cycle of debt for undisciplined spenders.

People with high-interest credit card balances might consider a personal loan to consolidate their debts and save on interest.

However, a personal loan is only your best option if you pay less over the life of the loan in interest than you would if you didn’t consolidate.

Emergency Expenses

A personal loan's lump sum can help you cover an unexpected emergency. You could also use it for a carefully planned expense if you have a clear payoff plan in place.

Planned Large Purchases

Personal loans can be a good choice when you’re looking to cover a large purchase and want a clear payoff date instead of carrying a credit card balance indefinitely.

When Is a Personal Loan a Bad Idea?

A personal loan is a bad idea if it would cause a financial burden or isn’t the proper solution for your financial issue.

Everyday Expenses

That's a sign of more deeply rooted financial issues and could warrant outside help.

Non-profit credit counseling agencies can offer free advice or negotiate with your creditors to set up a debt management plan (DMP) for a fee.

Existing Debt Struggles

In this case, you may need to explore more extreme debt relief solutions, such as debt settlement or bankruptcy.

Poor Rates

• Consumers with bad credit scores — under 580 — may find it difficult to get approved for a personal loan.

• While consumers with fair credit scores — 580 to 669 — have a better chance.

In both cases, APRs will be higher than they would be for consumers who have good, very good or excellent credit.

Unclear Repayment Plan

If you don’t have a clear repayment plan in mind, a personal loan isn’t a good idea. Consequences can include missed payments and credit score damage.

When Does a Personal Loan Actually Save You Money?

• When the APR is lower than your current debt

• When fees don’t outweigh interest savings

• When you stop adding new debt after borrowing

• When the repayment term doesn’t significantly increase total interest paid

• When payments fit comfortably within your budget

Quick Example: Does Debt Consolidation Save Money?

Before:

• A $10,000 credit card balance at 22% APR with a 2% minimum payment would require minimum payments of $200 per month, but most of that will go toward interest.

• Paying only the minimum will take over 30 years to pay off and result in a total payoff of almost $60,000 or about $50,000 in interest.

After:

• A 36-month $10,000 personal loan at 12% APR would have a fixed monthly payment of $332 and reach payoff in three years.

• The total payoff would be $11,957 or less than $2,000 in interest.

Result:

• The personal loan has a higher monthly payment, but you’ll pay it off faster.

• You would also reduce the total interest compared to carrying a credit card balance at a higher interest rate and only making minimum payments.

How Do You Get a Personal Loan?

Getting a personal loan is a straightforward process. Here are the basic steps:

1. Check your credit score.

2. Compare the best banks and rates.

3. Prequalify with a soft credit pull when available.

4. Gather required documents such as proof of income.

5. Submit your application.

6. Get approved and receive funds.

What Should You Watch Out for With Personal Loans?

Not all personal loans are the same. Here’s what to watch for:

• Taking on more debt than you can afford

• Origination fees and other charges

• High APRs if your credit score is lower

• Longer repayment terms that increase total cost

• Variable-rate loans

Personal Loans vs. Other Funding Options

Consider these alternatives if a personal loan doesn't fit your financial profile.

Credit Cards

You can skip interest entirely with a credit card if you pay your monthly balances in full. Most come with a grace period, giving you 21 to 25 days before your APR accrues on purchases.

If you need a little more time to repay a purchase or high-interest credit card balance, consider a 0% introductory APR credit card, which allows you to skip interest for a specified period, typically 12 to 24 months. You'll pay a fee for transferred balances, though.

Home Equity Line of Credit (HELOC)

A HELOC lets you borrow against the portion of your home that you own.

It's an option for homeowners who can qualify for a low interest rate, although you risk losing the property if you can't repay what you've borrowed.

Buy Now Pay Later (BNPL)

BNPL programs provide you with some money to pay for a purchase at the point of sale. You repay the funds over a short period of time at no to low interest.

If you miss a payment, you'll incur fees, however.

Is a Personal Loan Right for You?

Whether a personal loan makes sense depends on your needs and finances:

• Choose a personal loan if you qualify for a lower rate than your current debt.

• Choose it if you need predictable monthly payments.

• Avoid it if you’re already struggling with debt and it won’t solve your issue.

• Avoid it if you can’t commit to a clear repayment plan.

Key Takeaways

• Personal loans offer fixed payments and flexible use.

• They work best when used to lower interest costs or cover planned expenses.

• Rates depend heavily on your credit score and history.

• Fees and longer terms can increase the total cost you’ll pay.

• A clear repayment plan is essential.

Personal Loan FAQs

Still have questions about personal loans? Here are answers to some of the most common ones:

Is a personal loan a good idea?

A personal loan can be a good idea if you need the money for things like debt consolidation or emergency expenses. If you want money for nonessential spending, like a vacation or a shopping spree, it’s likely best to put money into savings until you meet your goal.

What credit score do you need?

In general, a score of at least 580 is needed to qualify for a personal loan. However, having a credit score in the 700s will get you much better rates.

Do personal loans hurt your credit?

When you apply for a personal loan, the lender will initiate a hard inquiry, which can temporarily drop your credit score up to five points for no more than 12 months. Additionally, if you miss payments or fail to make them altogether, your credit score can drop dramatically.

Can you use a personal loan for rent or bills?

Although it’s not ideal, you can use a personal loan for rent or bills.

Are personal loans tax-deductible?

Personal loans are not tax-deductible, but the interest may be. If you used the funds for qualified business, educational or taxable investment expenses, it’s likely deductible.

Do they have prepayment penalties?

It depends on the lender. Ask the lender if the loan includes prepayment penalties before signing on the dotted line. If so, it’s worth asking the lender to waive the penalties as a condition of you accepting the loan.

Jeanine Skowronski contributed to the reporting for this article.

Photo Credit: Fizkes / iStock.com