They can be expensive, but they’re sometimes your best option
A personal loan can be used for just about anything. Some lenders may ask what you plan to do with the money, but others will just want to be sure that you have the ability to pay it back. Though personal loans aren’t inexpensive, they can be a viable option in a variety of circumstances. Here’s how to decide if one is right for you.
How Personal Loans Work
Some kinds of loans are earmarked for a specific purchase. You can buy a home with a mortgage, purchase a car with an auto loan, and pay for college with a student loan. With a mortgage, your home serves as the collateral. Similarly, with an auto loan, the car you’re buying will be the collateral.
But a personal loan often has no collateral. Because it is unsecured by property that the lender could seize if you default on the loan, the lender is taking a greater risk and will most likely charge you a higher interest rate than it would with a mortgage or car loan. Just how high your rate will be can depend on a number of factors, including your credit score and debt-to-income ratio.
Secured personal loans are also available in some cases. The collateral might be your bank account, car, or other property. A secured personal loan may be easier to qualify for and carry a somewhat lower interest rate than an unsecured one. As with any other secured loan, you may lose your collateral if you are unable to keep up with the payments.
Even with an unsecured personal loan, of course, failing to make timely payments can be harmful to your credit score and severely limit your ability to obtain credit in the future. FICO, the company behind the most widely used credit score, says that your payment history is the single most important factor in its formula, accounting for 35% of your credit score.
When to Consider a Personal Loan
Before you opt for a personal loan, you’ll want to consider whether there may be less expensive ways you could borrow. Some acceptable reasons for choosing a personal loan are:
- You don’t have and couldn’t qualify for a low-interest credit card.
- The credit limits on your credit cards don’t meet your current borrowing needs.
- A personal loan is your least expensive borrowing option.
- You don’t have any collateral to offer.
You might also consider a personal loan if you need to borrow for a fairly short and well-defined period of time. Personal loans typically run from 12 to 60 months.3 So, for example, if you have a lump sum of money due to you in two years but not enough cash flow in the meantime, a two-year personal loan could be a way to bridge that gap.
