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When is getting a personal loan a good idea, and when is it a bad one?
Whether taking out a personal loan is a smart financial move or one that could sink you deeper into debt depends, at least in part, on the reason you want a loan. Good reasons, like reducing or paying off credit card debt, can help you improve your financial health. Bad reasons, such as buying things you can’t afford, can increase your debt and end up harming your credit.
Either way, a personal loan isn’t easy money or a quick fix. You should proceed with caution when getting a personal loan, even if it’s for a very good reason.
Good reasons to get a personal loan
People get personal loans for lots of reasons. Whether getting a personal loan is a good decision depends on your financial situation and habits.
The two most common, according to a recent Credit Karma study of approximately 1.5 million U.S. Credit Karma members, were to refinance credit card debt and to pay for unexpected expenses. Other reasons included making a major purchase, making home improvements and consolidating other debts.
And it’s not just lower earners who are sought personal loans for these reasons. The Credit Karma survey found that 10% of members who shopped for a personal loan to cover an unexpected expense had an annual income of $100,000 or more.
Whether a reason is good or bad depends in part on your financial situation and your feelings about debt. One of the good reasons is when a personal loan can help you improve your financial situation.
“Using a personal loan to consolidate and pay off credit card debt can be a good idea if you have accounts with high interest rates,” says Joe Toms, president and chief investment officer of FreedomPlus, a personal loans lending company in Tempe, Arizona.
Personal loans often have lower rates than credit cards, so they can help you consolidate your credit card debt as well as pay less interest on the debt overall.
Reasons to think twice
If your reason for getting a personal loan isn’t a necessity, won’t help you pay down higher interest debt, or only increases your total debt, you might want to reconsider. Some reasons you might want to think twice about getting a personal loan include paying for expenses you can’t afford, such as a lavish wedding, cosmetic surgery or an expensive vacation.
“If you need a loan to take a vacation, it likely indicates you’re living outside your means,” Toms says. “Few things are less relaxing than coming home from a vacation, going back to work and facing a pile of bills you can’t pay.”
Advantages of getting a personal loan to pay off credit cards
The average American in 2017 had credit card debt of $8,195 on average for credit cards and retail cards combined, Experian reported. As of the first quarter of 2018, the average credit card annual percentage rate was 13.63% on credit cards from commercial banks.
If you carry a credit card balance from month to month, an APR of nearly 14% could add up to a lot of interest. And keep in mind that this is the average. APRs can be even higher for people with lower credit scores or poor credit history.
Compared with credit cards, a personal loan can offer three main advantages: a single monthly payment for consolidated debt, a fixed interest rate and a fixed loan term, says Rachel Kampersal, marketing communications and programs associate at American Consumer Credit Counseling, a nonprofit credit counseling agency.
If you consolidate your debts through a personal loan, you may only have to deal with one payment instead of multiple payments. A single payment means you could only have to remember one date and amount to pay each month instead of several dates and minimums across multiple credit cards. That could make your debt easier to manage.
Credit cards can either have fixed or variable rates, but variable-rate credit cards are now very common. When you have a variable-rate credit card, your interest rate usually changes with the prime rate, as published in the Wall Street Journal. That means that your monthly payment and amount of interest you pay on your balance can increase or decrease per your credit card agreement.
Many personal loans have a fixed rate that doesn’t change based on an index. A fixed rate — and monthly payment — that’s lower than the various rates of your existing credit accounts could help you pay off your debt faster.
Fixed loan term
Personal loans typically have a set term for repaying the loan, whereas credit cards are a form of revolving credit, where you can determine how much you want to borrow and pay off each month as long as you make the minimum payment. And if you only make the minimum payment every month, it can take longer to pay off your credit card balance.
Having a fixed repayment term with a set monthly payment could make it easier to budget toward paying off your debts.
Other important notes about personal loans
What else should you know about personal loans before you take one out for debt consolidation? Here are a few things to know:
Personal loans are installment loans. That means the amount you borrow is fixed upfront. You’ll make regular monthly payments over the life of the loan, and when you make your last installment payment to pay off the loan in full, the account closes.
Secured or unsecured
Personal loans can be secured or unsecured. Secured loans require collateral, such as a savings account, that can be collected if you fail to repay the loan as agreed. Unsecured loans don’t require collateral but can come with higher interest rates.
Range of interest rates
Interest rates for personal loans typically range from around 5% to 36%, depending on the lender and your creditworthiness. To find out the rates you can qualify for and potentially save money on your loan, shop around for a lender.
Lenders may charge fees
Some lenders charge an origination fee for processing the loan (usually a percentage of the loan amount) or a prepayment penalty if you pay off your loan before the loan term ends. Again, shopping around could save you money, so be sure to ask about fees.
Credit scores matter
While personal loan can offer lower interest rates than credit cards, you may not qualify for lower rates if you have bad credit. Generally, the better your credit history and scores, the more likely you are to qualify for a lower interest rate on a personal loan.
Applying for a personal loan to pay off credit cards
Several types of lenders offer personal loans. Your choices may include banks and credit unions, along with consumer finance companies, peer-to-peer and online lenders.
The application process is fairly straightforward. Most lenders will check your credit reports and scores. But be aware that a hard credit check, also known as a hard inquiry, might lower your credit scores by a few points.Hard and soft credit inquiries: What they are and why they matter
You may need to supply personal information, such as your income and employer that show you have some steady income to make the payments.
“It’s important to have a good repayment history on previous loans and stable employment or income,” says Tia Sabawi, vice president of consumer lending at Xceed Financial Credit Union. “You also need to be comfortable making your new payment and able to demonstrate that you have the means to make the payment. Don’t borrow more than you can afford to repay.”
Words of caution
Despite these advantages, a personal loan can be risky if you don’t have a plan to repay it. A personal loan is debt. If you already have more debt than you can manage, swapping one debt for another might help for a little while, but ultimately it won’t solve your problem.
Getting out of debt will also require that you evaluate the factors that contributed to the original debt.
For example, if you use a personal loan to pay off your credit cards but continue to use your cards to spend more, you’ll end up with a loan and a pile of credit card bills. Or if you use a personal loan to pay emergency expenses but fail to save for future emergencies, you could just have to get another loan the next time an emergency comes up.
“It’s important to consider carefully how and when you’ll use personal loans and not get into a cycle of continually using them to pay down debt that you’ve racked up,” Sabawi says.
But there are steps you can take to address the debt you have and help avoid future debt. Consider getting an emergency fund started and working on a budget.
“Creating a budget and addressing the habits that got you into debt in the first place is important to avoid falling into the same situation with the new loan,” Kampersal says.Credit Karma Guide to Budgeting
Should you get a personal loan to pay off credit cards? That’s a personal decision. Only you can know for sure whether this type of loan makes sense for you. Still, some guidelines can help you decide.
- If getting a loan is all about spending, you might just be digging yourself deeper into debt.
- If you’re ready to use credit responsibly and are looking to pay off high-interest credit card balances, a loan could help you get a fresh start and better manage your finances.
- If you don’t already have good credit, it may be tough to qualify for low personal loan rates, and you may want to take steps to improve your credit before seeking a loan.
If you’re still not sure, you might want to do some research and compare offers before deciding if a personal loan is a good idea for you.