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One big advantage of personal loans is that they can provide borrowers with a large sum of money to help cover unexpected expenses, such as emergency repairs to a home or vehicle. A disadvantage of personal loans is that they can command relatively high interest rates and fees.Also, while personal loans may increase a borrower’s burden of debt, they can help consumers consolidate debt and build credit. Below we provide more details about personal loans and explain their pros and cons at length.
What Are Personal Loans and How Do They Work?Personal loans are installment loans that provide borrowers with a sum of cash to be repaid over a predetermined period in accordance with the terms and conditions of a loan agreement. Personal loans can either be secured with collateral, such as a home or vehicle, or unsecured. Consumers must submit an application requesting a certain amount of money to be considered for a personal loan.When lenders approve a personal loan application, borrowers may receive the money within hours, typically in the form of a checking account deposit. The way how personal loans work is that consumers receive all of the funds in one fell swoop and have wide discretion to spend the borrowed money however they see fit, with an obligation to repay the loan in accordance with specific terms set by the lender, including the length of the repayment period and interest rates.Recommended: Guide for First-Time Personal Loan Borrowers
Advantages of Personal LoansHere are some of the advantages to getting a personal loan:
Flexibility/VersatilityPersonal loans can have great flexibility in their terms and conditions, including repayment periods ranging from 12 to 84 months, and personal loans may provide borrowers with profound versatility to spend the loan on any given expense, planned or unplanned. Personal loans, for example, can cover an unexpected expense, or borrowers may use the funds to help finance a leisurely getaway, or even to finance the cost of getting a service dog. You could use a personal loan for wedding expenses, such as covering the cost of flowers for a wedding. Borrowers also may spend 100% of the personal loan on the first day of receiving the funds, or borrowers may sit tight on the borrowed money indefinitely. The borrower has great flexibility on how to use the personal loan.
Can Help Build CreditObtaining a personal loan and meeting your monthly repayment obligations can help build credit and may improve your credit score gradually. That’s because the most important factor in a FICO® Score is the consumer’s payment history, which showcases a consumer’s track record on making timely debt repayments to past and current accounts.If you apply successfully for a personal loan, make timely repayments on a monthly basis, and pay off the loan in good standing at the end of the repayment period, that may bolster your credit history and increase your access to credit.
Comparatively Low RatesThe average interest rate on a two-year personal loan stood at 9.39% during the third quarter of 2021, which was comparatively low in comparison with the 17.13% average rate on all credit card accounts assessed interest in that quarter, according to Federal Reserve data. Some lenders may offer lower rates on personal loans depending on various factors, including the borrower’s credit score, the amount being borrowed, and the length of the loan’s repayment period.
Relatively High Borrowing LimitsLenders may offer personal loans as low as $250 up to $100,000, providing consumers with relatively high borrowing limits to meet their needs. Borrowers with good credit may qualify for unsecured personal loans providing tens of thousands of dollars up front.
Unsecured Personal Loans May Not Require CollateralConsumers in many cases can obtain an unsecured personal loan, which is a lending product that does not require collateral for approval. Collateral is tangible property, such as a consumer’s vehicle, that a lender may seize or repossess if the borrower defaults on the loan. Examples of a collateralized loan include auto loans and mortgages, and sometimes a lender may require collateral for quick personal loans.
Relatively Easy to Manage When Consolidating DebtPersonal loans can be relatively easy to manage when consolidating debt. Consumers upon receiving the loan may use the borrowed cash to pay off outstanding balances on any open accounts, such as credit card bills, and then the borrower could exclusively focus on repaying the personal loan. This may allow borrowers to move forward with a more simplified debt burden.
Can Provide Fast Access to CashPersonal loans can provide consumers with fast access to cash. Once the application is approved, lenders in some cases may disburse the funds electronically within hours. Sometimes lenders may disburse personal loans as a physical check that may take five to seven business days to arrive in the mail.Recommended: Guide to Getting a $1,000 Personal Loan
Disadvantages of Personal LoansHere are some of the downsides that personal loans may bring to the table:
Interest Rates Higher Than Some AlternativesPersonal loans may carry higher interest rates than some alternative lending products. Auto loans and mortgages, for example, may command lower interest rates compared with unsecured personal loans, because collateral generally presents lenders with a lower level of risk in consumer credit transactions compared with lending products that do not require collateral.As mentioned earlier, the average interest rate on a two-year personal loan stood at 9.39% during the third quarter of 2021. That rate average stood lower than the 17.13% average rate on all credit card accounts assessed interest in that quarter, but the 9.39% average interest rate for a two-year personal loan easily eclipsed the average interest rates for 48-month and 60-month new car loans and new multifamily mortgages.Consumers may use personal loans for large purchases, such as a new vehicle, but alternative lending products may provide consumers with lower rates of interest. Personal loans in some cases may carry interest rates up to 36%.
Fees Can Be HighIn addition to the principal and interest, personal loans may feature additional fees, and these additional fees can be high. Such fees can include a loan origination fee ranging from between 1% and 8% of the loan amount. Some lenders may charge an application fee regardless of whether it had approved or denied the consumer’s personal loan request. At least 45 states and the District of Columbia impose interest rate caps on some consumer loans, and the median annual rate including all fees is 38.5% for a $500, six-month loan; 31% for a $2,000, two-year loan; and 25% for a $10,000, five-year loan, according to the National Consumer Law Center.
Significant PenaltiesPersonal loans may include significant penalties, such as:
Borrowers could face an NSF penalty if they attempted to make a monthly personal loan payment with a check that had insufficient funds to cover the expense. Lenders may return the bounced check to the borrower and assess a returned payment fee.Borrowers may also face late fees for any belated monthly payments during the life of the personal loan. Some lenders may charge prepayment penalties to borrowers who pay off their loan early.
- Nonsufficient funds (NSF) or returned payment fees
- Late fees
- Prepayment penalties
Higher Payments Than Some AlternativesPersonal loans may carry higher monthly payments than some alternative lending products. Personal loans are installment loans in which the borrower may make fixed monthly payments of principal and interest throughout the life of the loan, which can exceed the monthly minimum payments on revolving credit accounts.Credit cards, for example, can have monthly minimum payments as low as $35. Some credit cards with outstanding balances may require the cardholder to make monthly minimum payments equal to the sum of 1% of the cardholder’s new balance, periodic interest charges, and any late fees.A $3,000 personal loan with a 36-month repayment period and 10% interest rate would feature an estimated monthly payment of about $97 for the life of the loan.
Can Increase DebtTaking out a personal loan can increase your debt burden, particularly if you use the funds to make large purchases rather than using the funds for debt consolidation. For example, using a personal loan to fund a dream vacation will leave you with a new debt repayment obligation in addition to any other credit account obligations you may have.
Sometimes Collateral Is RequiredLenders sometimes require borrowers to offer personal property or collateral as a condition of approval for personal loans. Tangible assets, such as your vehicle or home, can serve as collateral. When borrowers offer an asset as collateral, that gives lenders the right to seize the asset if borrowers default on the loan.
Can Impact Credit Score NegativelyApplying for a personal loan can have a negative impact on your credit score. Lenders may conduct a hard inquiry into your credit history when you apply for a personal loan, and that could reduce your credit score by several points. Hard inquiries give lenders the ability to review an applicant’s credit history.Hard inquiries can help lenders evaluate an applicant’s debt burden and payments background, which can help lenders determine the potential risk of approving the applicant’s loan request. Borrowers who make late payments on a personal loan also could experience a negative impact on their credit scores.Recommended: What Are the Consequences of Lying on a Personal Loan Application?
Weighing the Pros and Cons of Personal LoansConsumers can weigh the pros and cons of personal loans by assessing both sides:
|Personal loans are flexible for meeting personal needs||Personal loans may command significant penalties|
|Personal loans can help you build credit||Personal loans can negatively impact your credit score|
|Personal loans may feature competitive interest rates||Some alternative lending products may offer lower interest rates|
|Personal loans could give borrowers large sums of money||Personal loan application and origination fees can be high|
|Personal loans may not require collateral||Sometimes collateral is required|
|Personal loans can promote debt consolidation||Personal loans can increase your debt burden|
Alternatives to Personal LoansHere are some alternatives to personal loans:
1. Credit CardsCredit cards are a revolving lending product that may allow consumers to make small or large purchases on credit. Credit cards can either be secured with cash as collateral or unsecured. A secured credit card is similar to how personal loans can be secured with an asset.Some credit cards may offer 0% promotional interest for up to 18 months, and any credit card account holder can avoid paying interest simply by paying their statement balance in full every month.Some credit cards also offer incentive programs or rewards that may provide cardholders with at least 1% cash back on any purchase.
2. Personal Line of CreditA personal line of credit is a revolving lending product that may allow consumers to borrow a certain amount of funds for personal spending. Borrowing money from a personal line of credit is comparable to taking out a personal loan.Similar to a credit card, personal lines of credit have maximum limits on how much funds the borrower can access and spend. Any money borrowed from a personal line of credit must be repaid by the borrower subject to terms of interest, but borrowers have discretion to make monthly minimum payments or higher.
3. Payday LoansPayday loans are short-term lending products that can provide consumers with small sums of cash, and borrowers are typically expected to repay the loan in a matter of weeks in full. Payday loans may feature high fees ranging from $10 to $30 for every $100 borrowed. Some states cap payday installment loan interest and fees at 36%. At least 45 states and the District of Columbia have rate caps for a $500, six-month installment loan, according to the National Consumer Law Center.
The TakeawayMillions of Americans take out personal loans every year, and that trend is expected to continue in 2022 with prime and nonprime borrowers. Whether you need money to cover unexpected expenses or money to finance a dream vacation, having access to credit remains as important as ever.Lantern by SoFi can help consumers find and compare personal loan options. All you need to do is provide basic information about yourself and the loan you need, and Lantern can present key data guiding you in the process to apply for a personal loan with the lender of your choice.
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About the Author
Sulaiman Abdur-RahmanSulaiman Abdur-Rahman writes about personal loans, auto loans, student loans, and other personal finance topics for Lantern. He’s the recipient of more than 10 journalism awards and currently serves as a New Jersey Society of Professional Journalists board member. An alumnus of the Philadelphia-based Temple University, Abdur-Rahman is a strong advocate of the First Amendment and freedom of speech.