Have you found yourself wide awake at 3 a.m. — not because you’ve just seen It Chapter Two, but because you need money? Are you mulling the pros and cons of a personal loan?
You’re not the only one who’s worn a groove in your computer keyboard by punching numbers into an interest rate calculator. Personal loan balances increased $21 billion in the last year to close 2018 at a record high of $138 billion. The actual number of people taking them out amounted to just over 19 million, according to Transunion.
“As a general rule, personal loans make sense when the person taking out the loan has a clear, specific reason for obtaining the loan, and a clear plan for repayment,” says Shiva Bhaskar, head attorney and cofounder for Tier One Credit, a full-service credit repair firm based in California. “In my experience, one of the best reasons for personal loans is to pay down high-interest debt, especially credit card debt, with the lower interest debt of a personal loan.”
Hold Up — What Is a Personal Loan, Anyway?
A personal loan is an unsecured loan that you borrow from a bank, credit union, or online lender. An unsecured loan is one that isn’t backed by collateral. In other words, your lender won’t be able to repossess your car or home if you don’t pay back a personal loan.
You pay this money back in installments over time. Plus, unlike other types of loans (such as student loans or auto loans), you can use a personal loan for almost anything you want — and that’s the attraction. Read on for a few good reasons why a personal loan might be a good fit for you.
Reason 1: Outsmart Your Credit Card Debt
You’ve read the articles and have heard Dave Ramsey’s apocalyptic voice booming from the radio: “You must break free of credit card deeeeebt (echo, echo, echo).”
You’ve also talked to actual people about how they screeched the brakes on their high-interest debt.
The end result? Happy, high-interest-free people who look like they’re all in an allergy medication commercial.
You know, the ones where they play with puppies in giant fields of flowers? They say things like, “The world is finally breathable” and “I can see clearly now” and “It’s like finally being able to break free.”
Too much of an exaggeration? Okay, maybe. But it truly is a freeing feeling to dust your hands of the high interest rates on your credit cards. Consider this: The average cashback credit card APR is 24.36 percent. Compare that with the average personal loan interest rate and you’ll instantly want to dance with the puppies among the flowers: Personal loan interest rates can be as low as 6 percent.
Here’s how a very real scenario could play out: Let’s say you have $15,000 on your credit cards at 15 percent interest. You get a personal loan at 8 percent interest. You could potentially cut your interest payments by more than 50 percent.
Still, it’s important to think very carefully before taking out a personal loan for credit card consolidation, for one major reason: “Many people will charge their credit cards back up after consolidating them, and then have a loan payment and the credit card payments,” says Carey Zielke, personal finance expert and owner of the blog Realities and Dreams.
Pro tip: Don’t let your credit cards tempt you again. A good way to resist using them is to put them in a locked drawer or safe or to let a trusted friend or family member hide them from you.
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Reason 2: Buoy Your Home’s Resale Value
Should you use a personal loan to fund purchases? “This option should be used only if the purchase is essential, a need. If it’s for a purchase that you want, then taking out a loan for it is a bad idea,” says Zielke.
Here’s the distinction:
Let’s say you’re planning to sell your home in about a year or so because you know you’ll need to move to a particular city to advance your career. You desperately need a new roof on your home because no buyer will look twice at a home with a crumbling roof.
Sure, you could get a home equity loan or home equity line of credit and fix the problem. However, these types of loans require you use your home as collateral, which means you’re at risk of losing your home to your lender if you default. The thought of risking your home like that might make you feel pretty icky inside.
Now let’s look at another scenario. Let’s say your kids have been begging you for the past 10 years to put a pool in the backyard. So you do, despite the fact that none of your neighbors have a pool and also despite the fact that you live in Alaska.
Think a pool is going to do much for the resale value of your home? Nah.
See how those two scenarios illustrate when a personal loan is a good idea and when it’s not? Think want versus need. Ask yourself: Is it as necessary as homeowners insurance (a major must-have)? A good real estate agent can help you determine whether an addition, pool, or other project will actually boost your resale value.
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Reason 3: Boost Your Credit Score
Your credit score plays a big factor in determining how much you can get in a personal loan. Your credit score is the three-digit number that ranges from 300 to 850 and serves as a predictor as to how well you’ll pay off debt. But in some situations, you might also be able to improve your credit score once you actually receive a personal loan.
“It can lower your overall credit utilization and establish more credit history, among other things,” Zielke says.
One major component of your credit score is credit utilization, which is the ratio of your outstanding credit card balances to your credit card limits. Your credit utilization sums up the amount of credit you’re using. For example, you might have $200 on your credit cards and your credit limit might be $1,000. Your credit utilization for that particular credit card would be 20 percent.
Your credit utilization will naturally go down on your credit cards if you’re using them less. As a result, your credit score could increase.
How else can a personal loan help your credit score? It can help diversify your credit, particularly if you’ve only been carrying credit cards. Part of the secret sauce of what makes up your credit score depends on a variety of loan types. A personal loan is an installment loan, and credit cards are revolving loans.
See? You’ll have two different loan types on your “credit résumé” right there.
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Watch for a Few Other Things Before Getting a Personal Loan
You’ll naturally want to ask a lot of questions when you’re borrowing money. Before you decide on a lender, ask yourself the following questions.
1. How Does the Lender Compute Interest?
Some financial institutions calculate interest on a pre-computed basis. “This means that if you pay off the loan early, you will pay more interest than if it was computed with the simple interest method,” says Zielke.
2. Is the APR Variable?
Some banks lure you with a low APR, but might also charge you for other services. Some common service charges you might see include origination fees, underwriting fees, credit check fees, and repayment fees. You’ll save a lot of money if you choose a lender that offers low or no fees and limited charges.
3. What’s Your Credit Score?
Reasons for Personal Loans: The Bottom Line
Do your homework and ask lots of questions.
“Paying only minimum payments on credit cards can lead to years of payments, all while paying interest to the financial institution. Taking out a personal loan can substantially lower your interest versus a credit card and also has a definitive payoff date,” says Zielke.
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