You can use a personal loan for a variety of things. For instance, consolidating credit card debt, consolidating student loans, or dealing with unexpected medical bills. Of course, they can be used to finance many other things like starting or growing a business, home repairs, etc. However, before getting a personal loan, it's important to understand the pros and cons of personal loans.
It's also important to be mindful of how you leverage debt. So in this article, we will discuss what to consider before applying, personal loan advantages and disadvantages, and how lenders determine personal loan eligibility!
What is a personal loan?
A personal loan is a lump sum of money that you receive from a lender with an agreed-upon payback plan typically that can be anywhere from a few months up to 5 years. They are also unsecured loans. This means you do not have to use an asset as collateral for the loan.
Since there is typically no collateral associated to back the loan, personal loans typically come with higher interest rates. A salary advance loan, if your employer offers it, could fall under the personal loan category, but these are typically short-term loans.
Determining personal loan eligibility
How do lenders determine personal loan eligibility? In order to be deemed eligible for a personal loan, lenders will look at your credit report and income in order to make a lending decision.
Specifically, they will look at your debt-to-income ratio (DTI), which measures your monthly debt payments as it compares to your monthly gross income. Lenders will also look at the history of how you've paid your debt in the past.
One thing to keep in mind is that gross income is your income before any taxes or other deductions are taken out.
Why does knowing this matter? Well, when it comes to paying back your loan, you'll be doing it with your income after taxes and other deductions have been taken out. This means, although you may qualify for a large loan, you'll want to ensure you can truly afford to pay back the loan with your post-tax earnings.
Many online lenders offer personal loans at competitive interest rates. You can also apply for a personal loan at a bank where you already have a relationship.
If you find yourself needing to leverage a personal loan, it's a smart idea to determine how much you really need beforehand. This way, you don't take on more debt than you have to. It's also smart to create a debt repayment plan as soon as possible. This will help you with a strategy to pay back the loan quickly.
What to know before you apply for a personal loan
Before you apply for a personal loan, there are a few key things you need to keep in mind.
Be clear on your interest rate
When it comes to personal loans, your interest rate makes all the difference in your monthly payments and the total cost of the loan. As a result, it's essential you know what interest rate you are getting and whether it's a fixed or variable interest rate.
Variable interest rates can be attractive at first because they usually start off low. However, they can increase dramatically over time, making your loan extremely expensive.
Make sure your lender is reputable
There are tons of online lenders offering all kinds of attractive personal loans. However, there are a lot of unsavory loans out there, including payday loans which are a bad idea.
If you are concerned about the trustworthiness of a potential lender, visit the Consumer Financial Protection Bureau at consumerfinance.gov for more information on protecting yourself.
With that being said, let's dive into the personal loan advantages and disadvantages to help you decide if it's the right decision for you!
Top pros and cons of personal loans
Of course, before you jump into getting a loan, you need to know the pros and cons first. Here is a list of the pros and cons of personal loans so you can decide if it's best for you!
Pros of personal loans
Let's start on a positive note and get into the advantages of a personal loan first!
Lower interest rates
The interest rate is one of the biggest deciding factors when weighing the pros and cons of a personal loan. The good news is, if your credit score is good, you can get a lower rate for a longer term than you can on a credit card.
Sure, credit card companies offer 0% APR promotions, but can you pay off the full amount by the end of the promotion terms? If not, then a personal loan with a lower rate may be the best way to go.
Consolidate debt easier
Some people find that consolidating debt into a personal loan simplifies their finances. So rather than having five payments to different lenders, you would have one payment to one lender.
This could make budgeting and managing your money much easier. However, you need to ensure you don't take on more debt if you do decide to go this route.
Builds your credit
A personal loan can help you build your credit as long as you make your payments on time. Lenders will review your payment history of loans to see how responsible you have been with paying your loans back. This can help establish credit history and build your score.
Cons of personal loans
Although there are a few pros to a personal loan, there are also some cons. Let's dig in and view a few:
Personal loans can have high fees and penalties
One disadvantage of a personal loan is the origination fee. An origination fee is separate from the interest charged on the loan. This is a payment associated with establishing the loan account, and it is calculated as a percentage of the total loan.
This percentage can range anywhere from 1% to 10%. As a result, origination fees can add considerable costs to a personal loan.
Other fees to consider include:
- Transaction fees
- Late payment fees
- Pre-payment fees (discussed below)
Transaction fees, late payment fees, and origination fees are among the top disadvantages of a personal loan.
Can affect your credit score negatively if you can't make payments
One major disadvantage of a personal loan is if you are unable to make on-time payments or if you fall behind on your payments, it will impact your credit score.
Remember, you'll need to make sure you are not taking on more debt than you can afford to pay. But as we said before, if you are consistent with your on-time payments, it will have a positive impact on your credit score.
Could have prepayment penalties
Prepayment penalties are another disadvantage of a personal loan. Depending on your lender, they may not allow you to make extra payments or pay your loan off early. If you are able to pay it off early, you could incur a prepayment penalty for doing so.
So before you sign anything, make sure you understand the prepayment rules. Many lenders have no prepayment penalty so be sure to confirm this before you commit to a loan.
Consider the personal loan advantages and disadvantages before you make a big financial decision of taking on debt.
Weigh the pros and cons of personal loans before applying!
A personal loan can help you strategically pay off debt faster. For instance, consolidating debt into a personal loan may help to reduce your interest rate and lower your monthly payments. It can also help you cover major expenses like medical bills.
However, before applying, consider the pros and cons of personal loans, do your research, run your numbers and determine what will work best for you. Determine what you can truly afford and create a plan to pay back your loan as quickly as possible.