5 benefits of personal loans — and 7 drawbacks to consider
Published 12:03 AM EDT, Thu April 11, 2024
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The primary benefit of a personal loan is that it can get you out of a financial jam. And since it typically carries a relatively low interest rate, a personal loan can be a more cost-effective solution than the plastic in your wallet. In fact, that’s one reason you might use a personal loan: to consolidate and pay off credit card (or other higher-APR) debt.
Unlike credit cards, a personal loan has a finite repayment period, which means you can put an expiration date on your debt. Making your payments on time can also help you improve your credit scores and reports over time.
The drawbacks of these loans — including the fact that your credit can suffer if you fall behind on payments — should be weighed carefully. But whether you should borrow hinges on whether you have better alternatives and can realistically afford repayment.
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5 key benefits of personal loans
If you’re considering a personal loan, first compare their features to other types of loans and credit cards. In particular, consider the requirements to qualify, the cost to borrow and the impact to your credit.
“If your options are a personal loan or putting high dollar amounts on a credit card, it is a good time for a personal loan,” said Cameron Smith, vice president of lending at Neighborhood Credit Union. “Interest will be much less on a personal loan than using a credit card, and having a set maturity date will keep you out of a potential cycle of paying minimum payments like you do on a credit card.”
1. Consolidated high-interest debt
The benefit: It’s a solid strategy for managing credit card debt.
In late-2023, US consumers’ credit card debt reached historical highs, surpassing $1 trillion, according to TransUnion. If you have credit card debt, an aggressive repayment strategy can help.
Paying off high-interest debt (credit card or otherwise) with a personal loan — also known as consolidating debt — could lower your interest rates and maybe even reduce your monthly payments.
As of November 2023, the average APR on a 24-month personal loan was nearly half the rate of credit cards, at 12.35% versus 21.47%, respectively. Here are current personal loan rates:
In addition to the rate reduction, using a personal loan to pay off multiple credit cards lets you consolidate several payments into one, reducing the risk of missing a due date.
Related >> The best debt consolidation loans of 2024
2. A set payoff date
The benefit: You won't be stuck in an endless cycle of debt payments.
With credit cards, your debt has no expiration date. In fact, you can make the minimum payment every month and there's a chance you'll never pay off the full balance.
By contrast, personal loans have a set payoff date. In the third quarter of 2023, the average repayment term (or length of time to repay) on a new personal loan was 33.4 months, according to TransUnion. Although each lender offers unique terms, the best personal loans typically feature repayment terms between one and seven years or longer.
3. No collateral
The benefit: Your personal property isn’t at risk.
Most personal loans are unsecured, meaning there's no collateral required to qualify. Instead, lenders spotlight your credit scores and reports, debt-to-income ratio and other financial factors to determine your eligibility and interest rate.
While secured personal loans have lower average APRs (and less strict credit requirements), you risk losing your property if you fall behind in repayment.
4. Improved credit
The benefit: Qualify for better rates and rewards in the future.
With most credit cards and loans, your monthly payment history is reported to the three credit reporting agencies — Equifax, Experian and TransUnion.
Repaying a personal loan on time can help you increase your credit scores, since payment history is the most important factor in determining them. Plus, having at least one active installment loan can diversify your credit mix, which can also give your scores a boost.
5. Quick access to cash
The benefit: Loans give you a lump sum of money upfront.
Time is of the essence if you need fast funding. The best online loans offer a streamlined application and can deposit the loan into your account as soon as the same or next day after you’re approved.
Just make sure you take the time to understand the loan terms before you accept, since a loan is a long-term commitment.
7 drawbacks of getting a personal loan
A personal loan can help solve a short-term financial problem, but it can also create more problems down the line. Even if a loan helps you pay off credit card debt or cover an emergency, you'll still need to manage repayment, often for years.
"If you don’t have a plan for how the money will be used and how you'll pay it back in a timely manner, a personal loan might not be the right option for you at this time," said Smith.
1. Credit score requirements
The drawback: With poor credit, you might not qualify (or you’ll get rates that rival credit cards).
Not everyone will be quoted the lowest personal loan rates or even qualify for a loan at all. That's because your credit scores play a direct role in what you get approved for.
If you want to reduce your rates, apply with a cosigner or improve your credit scores first.
Expert take: "Improving your credit score is the key to qualifying for a good personal loan at the lowest interest rate and the best possible term," said Bola Sokunbi, a New York City-based certified financial education instructor. Sokunbi recommended pulling your free credit reports via AnnualCreditReport.com to see where you stand before applying. And to improve your credit scores, "make your debt payments on time each month with a focus on reducing your balances, and minimize new credit inquiries.”
2. A new expense
The drawback: Payments on the new loan could break your budget.
Before you borrow, it’s critical to set your budget and confirm that you have room for a new monthly loan payment.
Of course, even the best-laid plans can go out the window pretty quickly, and therein lies the drawback of borrowing a personal loan: Will you still be able to afford your monthly dues if your budget breaks? Perhaps you borrow a loan to repair your car, for example, right before your furnace stops working.
To mitigate the risk of a suddenly unaffordable loan payment, borrow as little as possible, and create as much breathing room in your budget as you can.
3. Borrowing costs
The drawback: Interest rates are historically high, even on personal loans.
Interest rates on personal loans are lower than on credit cards and payday loans, but that doesn't mean they're economical.
Example: Let’s say you have an average FICO credit score of 718. In early April 2024, you might qualify for a personal loan with a three-year term and a 21% APR. That might not seem outrageous until you plug the numbers into a free online loan payment calculator (like Calculator.net’s). For a 10,000 balance, you'll pay $3,563 in interest to the lender. By contrast, with a 10% APR, your interest charges would drop to $1,616.
Beyond interest, personal loans have other costs. Most notably, origination fees range from 0% to 12% of the loan amount (varying by lender) and are withdrawn from the loan before it hits your account. If you proceed, prioritize lenders that don’t charge origination fees.
4. More debt
The drawback: You'll take on a new debt obligation.
In 2023, the year-over-year average account balance on personal loans grew by 6.2%, and borrowers with personal loans now owe a record-high average of $11,773, according to TransUnion. Paying off debt can be stressful at any time, but between the high cost of living and elevated interest rates, it may be harder to pay off a loan than you think.
5. Loan use restrictions
The drawback: You might not be able to use the loan for your intended purpose.
Personal loans can be used in many ways, but there are some expenses that they can’t be used for, including:
Most commonly, lenders won’t offer funding for illegal purposes or even legal but suspect industries, such as gambling, cannabis and pornography.
It's also unwise to use a personal loan to pay off federal student loans since personal loans don't offer the same repayment flexibility. Additionally, you don't want to use a personal loan to buy a car or home, since auto loans and mortgages are typically much more affordable than personal loans.
6. Amortization
The drawback: Amortization can make loans an expensive solution for short-term problems.
Amortization refers to portions of your payment going toward interest and the principal of your loan. Early in repayment, a majority of your payment goes toward interest, but it reduces over time.
Example: For a $15,000 loan with a five-year term and a 15% interest rate, the monthly payment would be $357. For the first payment, $187.50 would go to interest charges alone, but by the last payment, just $4.41 will go to interest.
This matters because amortization can make a loan unnecessarily expensive in cases of short-term repayment. If you can cover your expense with a credit card and pay it off at the end of the month — or within an introductory 0% APR period — you'll avoid interest charges altogether. In these scenarios, using a credit card is more affordable than a personal loan. For small-dollar, short-term loans, you might also consider loan apps as a viable alternative.
7. Penalties for non-payment
The drawback: If you can't cover the payments, your credit and finances will take a hit.
If you can't afford personal loan payments, you'll have problems down the line.
| Time frame (days) | Consequences |
|---|---|
1 to 29
| Late fees and interest charges begin accruing.
|
30 to 180
| For every 30 days you’re late, a missed payment can appear on your credit reports. Missed payments stay on your reports for seven years and can cause a huge initial drop in your credit scores.
|
More than 180
| The creditor may close the account and charge it off to collections, causing another drop in your scores. The creditor may also take legal action to collect the money from you.
|
When to get — or avoid — a personal loan
Even if the benefits of personal loans seem to trump the drawbacks, only pre-qualify for a personal loan if you fully understand the loan terms and are sure that repayment realistically fits within your budget.
"A big misconception about personal loans is that they will fix all of your financial problems," said Bola. "While they can provide short-term relief, personal loans are an added debt burden you will need to pay back and can add to financial strain if you can't afford to make the monthly payments."
If the monthly dues on a loan comfortably fit into your budget, a personal loan can have benefits, particularly if you use it to pay off credit card debt. For example, if your credit cards each have 20%-plus APR and you have the credit scores (or cosigner) to get a personal loan with a single-digit APR, using the loan to pay off the cards could save you significant interest.
| When to get a personal loan | When to avoid a personal loan |
|---|---|
|
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Frequently asked questions (FAQs)
As with any type of credit (including credit cards and loans), paying your monthly bill adds a positive payment history to your credit reports. The longer your history of making monthly payments, the higher your scores will be.
If you don’t have any loans, a personal loan can also help your credit scores in the area of “credit mix,” by adding a new type of credit to your mix of accounts. (However, this in and of itself, isn’t a great reason to borrow.)
Each lender has limitations on what you can use a personal loan for, but many will restrict you from using the money for higher education expenses, business purchases and investing.
The borrowing limits for personal loans depend on the lender, but some lenders offer $100,000 or more. Generally speaking, you can qualify for higher limits if you have good credit and a steady income. In the third quarter of 2023, the average personal loan amount ranged from $2,000 to $18,700 for borrowers in the lowest and highest score tiers, respectively, according to TransUnion.
Most personal loans are unsecured and don’t require collateral. The trade-off, however, is that interest rates are higher on average for unsecured loans than they are for secured loans.
Editorial Disclaimer: Opinions expressed here are the author's alone, not those of any bank, credit card issuer, airlines, hotel chain, or other commercial entity and have not been reviewed, approved or otherwise endorsed by any of such entities.
This content is for educational purposes only and is not intended and should not be understood to constitute financial, investment, insurance or legal advice. All individuals are encouraged to seek advice from a qualified financial professional before making any financial, insurance or investment decisions.
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