Do you have a wedding on the horizon? Are you finally starting those home renovations you’ve been planning for years? If so, you might be considering taking out a personal loan. Personal loans are a great way to get money when you need it fast. However, as with any type of loan, there’s also some risk involved. To decide whether or not it’s the best option for you, you first have to understand the pros and cons of personal loans.
What is a personal loan?
A personal loan is a type of installment loan, which means the borrower receives a lump sum of money that is repaid via monthly payments over an agreed-upon term length. Unlike auto loans and home loans, which have very narrow usage requirements, personal loans can be used for almost anything. Some popular uses include medical bills, home improvements or repairs, and other large purchases. Personal loans can also be used as a pathway for debt consolidation1.
Personal loans are distributed by online lenders, banks, credit unions, and other financial institutions. Interest rates on personal loans can vary widely, but they often hover around 9% and 10%. Most lenders will make you an interest rate offer depending on your credit score, loan term, and requested loan amount.
Secured versus unsecured personal loans
There are two types of personal loans: secured and unsecured. With secured personal loans, you’ll need to exchange some type of collateral with the lender in return for the requested loan amount. This could be, for example, a home, car, stock market holdings, etc. This offers the lender some assurance that they’ll recoup the value of the borrowed funds, and they’ll hold onto your collateral until the loan is paid in full.
An unsecured personal loan does not require collateral to back the loan. Instead, these are approved based on the creditworthiness of the borrower. Because unsecured loans are riskier for the lender, they typically carry higher interest rates than secured loans.
The advantages of a personal loan
Personal loans can have many advantages for borrowers under the right circumstances. Let’s take a look at a few.
Flexibility
Personal loans can be used for almost anything, from organizing your personal finances via debt consolidation to covering an emergency expense. Here are a few of the most common uses.
Home Renovations: Thanks to materials and labor shortages, the cost of home improvements has been soaring. Remodeling a bathroom or kitchen can cost thousands of dollars. If you need to make a critical repair or add value to your home ahead of a property revaluation, and using a credit card or payment plan is not an option, a personal loan offers one solution.
Moving costs: Moving expenses can add up quickly. A personal loan can help you cover the cost of shipping your belongings, transporting your vehicle, or even purchasing new furniture.
Weddings: Your dream wedding doesn’t come cheap. In fact, the average wedding cost in 2021 was around $28,000. A personal loan can help you cover the venue, photographer, catering, and other fees.
Debt Consolidation: If you’re juggling multiple high-interest-rate credit card balances, you can use a personal loan to consolidate and therefore simplify your credit card debt. This can be a smart financial decision for someone with credit cards that carry a high interest rate, since you can often get a lower rate on a personal loan. In some cases, that could help you save thousands of dollars over the life of the loan.
Buying a Vehicle: Typically, when purchasing a car from a dealership, an auto loan will give you more favorable rates and terms than a personal loan. However, if you’re purchasing a vehicle from a private party and auto financing is not an option, a personal loan can be a good alternative.
Other Large Purchases: Sometimes, unavoidable circumstances arise that require an immediate remedy. If your transmission blows out on your only car, or your home’s HVAC unit stops working in the middle of winter, you need a solution fast. Personal loans can get you back up and running quickly.
Of course, there are also some cases where you would not want to use a personal loan. For instance, making a down payment on a house or purchasing a car from a dealership are both situations where you can obtain lower interest rate loans from other sources.
Lower interest rates on average
Personal loans tend to have competitive interest rates when compared with other lines of credit. For instance, credit cards carried an average interest rate of 16.5% in 2021 according to data collected by the Federal Reserve. Data from this same time period showed a 24-month personal loan rate average of about 9.5%. The interest rate you’re offered will be dictated by your loan principal, loan term, and other aspects of your financial situation, including your credit score as reported by the major credit bureaus. Borrowers with poor credit may receive interest rates well higher than the average.
One lump sum
Another benefit of a personal loan is that the money is provided in one lump sum. This gives you ultimate flexibility to make large purchases or cover other expenses. That’s in contrast to something like a credit card, which doles out credit over time and may have lower limits than you need. With a personal loan, you get the money upfront and can use it immediately.
Quick approval process
The approval process for a personal loan is pretty fast — usually only about 24 hours. As with other types of loans, you’ll have to submit some personal information, and the lender will likely check your credit report, which may affect your credit score. They’ll also verify your employment and home address and analyze any other outstanding debts you may have to assess your creditworthiness.
May not require collateral
Unsecured personal loans do not require collateral. As such, they typically carry higher interest charges than secured personal loans because they pose more risk for the lender. However, if your personal finances are in good standing, you could still receive a competitive rate without having to leverage any of your assets to receive the loan.
Reasonable monthly payments
Personal loans often have longer loan terms than other financing options. This makes monthly payments more reasonable for the borrower. The longer the term, the lower the monthly payment. At the same time, it’s important to remember that with a longer term, you’ll ultimately pay more in interest over the life of the loan.
Useful for refinancing
If you have credit card debt or other existing types of debt, a personal loan can provide a way to refinance or consolidate it. This can simplify your monthly payments and even save you money by helping you secure a lower interest rate, switch from a fixed to a variable interest rate, or select a new loan term.
The disadvantages of a personal loan
Personal loans can offer immediate financial relief for all kinds of borrowers, but they’re not right for everyone. Here are a few cons of personal loans to consider before you move forward.
Hard on borrowers with bad credit
Personal loans tend to have higher interest rates for borrowers with poor credit. If you have a low credit score, (possible if your credit history includes bankruptcies, spotty payment history, or other high balances) personal loans might not be your best option. If you’re not sure what your credit score is, you can check your credit report by requesting it from the major credit bureaus (Transunion, Equifax, and Experian). You can do this once per year for free via annualcreditreport.com.
Strict eligibility requirements
Personal loans can require more from potential borrowers than other types of loans. Some lenders require an individual to have a minimum credit score of 600 and a debt-to-income ratio no more than 35%. Each lender is different, but some have fairly stringent requirements that may make them harder to qualify for.
Potentially high fees
Some personal loans also carry fees, which can add up and inflate the cost, making monthly payments untenable for some borrowers. A few common fees include
Origination fees: Some banks, credit unions, or other lenders will charge a loan origination fee to cover costs associated with processing the loan. These fees will often be added to the total loan amount. Origination fees are usually a percentage (1 to 6%) of the total amount borrowed.
Application fees: These cover the initial expense of processing and reviewing your loan application. Application fees are typically an upfront cost, and won’t be refunded even if the applicant does not qualify for the loan. While these fees are uncommon for personal loans, it’s still a good idea to ask before you apply.
Prepayment penalties: Some lenders charge a penalty if the borrower pays off their loan before the end of their loan term. This helps the lender recoup the cost of the interest you would have paid over the full term. Prepayment penalties are usually a small percentage of the original loan amount.
Late fees: These are common across many types of loans, including personal loans. You could incur these by missing a monthly payment or failing to pay off the loan in full by the end of the term. Late fees are usually a flat fee but can also be a percentage of the monthly payment amount, depending on the conditions of the financial institution.
Is a personal loan right for me?
A personal loan can be helpful for borrowers who fit the right criteria. You likely are a good candidate for a personal loan if:
You have high-interest debt that would benefit from consolidation.
You have a good credit score or have collateral to leverage.
You have a reliable source of income and can meet your monthly payments.
Your debt-to-income ratio is lower than 35%.
You have a reliable track record of making on-time payments.
Personal loan alternatives
There are many alternatives to personal loans. Depending on your financial situation, some of these could be better options. Here are a few of the most common.
Credit card
A credit card is a revolving line of credit offered by a financial institution. Credit cards can be used to make everyday purchases. They carry a max spending limit based on the creditworthiness of the cardholder. If you make your monthly payments on time, you won’t usually incur any fees. If you just make the minimum monthly payment, your remaining balance will be carried into the next month. Your interest then compounds and can add to the balance due.
Credit cards sometimes carry great perks, such as cash-back and travel rewards. They can offer low introductory rates such as 0% APR for the first 12 months. However, many start to charge high interest rates after that introductory period. Credit cards are great for everyday use as long as you can keep up with the payments. Otherwise, compounding interest and late payments can quickly inflate your overall debt.
Personal line of credit
A personal line of credit (PLOC) is similar to a credit card. In this agreement, an individual receives a spending limit and repays their total monthly expenses at the end of each month. However, unlike a credit card, a borrower may withdraw funds from their PLOC.
A PLOC is a type of term loan. This means that the loan has an expiration date. If your loan term is two years, for example, the PLOC balance must be paid back in full at the end of those two years. A PLOC might be a good choice for you if you’re expecting a large expenditure and happen to qualify for a lower interest rate. To find out, you can contact your bank, credit union, or another financial institution.
Payday loan
A payday loan is a short-term loan, typically around $500 or less, that’s due within a week or two of the borrowing date. The loan is usually repaid in a single payment once the borrower receives their next paycheck. This type of loan generally carries high fees. Lenders may charge $10 to $30 for every $100 you borrow, which is an extremely high percentage given the small loan amounts.
This type of loan is typically used as an advance on a paycheck that is guaranteed to come in. If you have bills that need to be paid prior to payday, this option can help avoid penalties for falling delinquent on those services.
Home equity loan
If you are a homeowner, a home equity loan is another financial option. This type of financing allows someone to borrow money based on the equity they have in their home. Equity is calculated by the home’s current market value and the remaining mortgage loan balance on the home.
This option is obviously only useful for homeowners. The downside to a home equity loan is that you’re leveraging your home as collateral — which means it could be partially or fully repossessed if you fail to pay the loan.
Home equity line of credit (HELOC)
With a home equity line of credit (HELOC), a borrower receives a revolving line of credit that is awarded based on the equity value in their home. Instead of a lump sum of money, borrowers pay based on what they use, similar to a credit card or PLOC.
The ideal borrower is a homeowner who has built substantial equity in their home, and who can also afford to make payments on the money being drawn.
Find the best personal loan with Navient Marketplace
Personal loans are a great option for someone who needs quick access to funds. They can be used for almost anything, including home renovations, travel, weddings, and even debt consolidation.
Whether you’ve already decided that a personal loan is right for you, or you're still doing your research, the Navient Marketplace is a great place to get started. Navient is an industry leader in loan originations and loan servicing, and has recently partnered with top-tiered financial institutions to build a comprehensive online platform that can help you choose the option that fits you best. Stop by today and see if a personal loan is right for you.