Taking out a personal loan can make a lot of sense under the right circumstances. But there are also times when it can be the wrong financial choice.
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Personal loans have many significant advantages over other types of loans, such as credit cards. The interest rate on a personal loan is typically well below the standard APR on a credit card. And personal loans come with fixed repayment terms and predictable repayment schedules, so there’s no risk of getting mired in debt forever as there is with a credit card.
But just because personal loans can be an affordable way to borrow doesn’t mean it’s always a smart idea to take out a personal loan. In these five situations, borrowing from a personal loan lender can be a big mistake.
1. When you can't get a loan at a reasonable rate
There are all sorts of personal loan lenders that cater to borrowers with different credit histories and different borrowing needs. Unfortunately, some of those personal loan lenders are unscrupulous and charge very high interest rates and high origination fees.
It’s important to look at the Annual Percentage Rate, or APR, to find out the total annual cost of borrowing. If you’re going to be paying upwards of 30% a year, this is well above the typical credit card interest rate and can be extremely expensive. Taking out a loan at such a high rate could mean paying hundreds or even thousands of dollars in interest -- and it’s just not worth doing unless you have no choice but to borrow and no other borrowing options.
You should aim to get the lowest possible rate on your personal loan by shopping around with several different lenders. If you can’t qualify for loans at a low rate with any of them, try improving your credit or getting a cosigner and trying again. Otherwise, forego borrowing until your financial situation changes -- unless you have no other options.
2. When a different kind of loan would provide better borrower benefits
While personal loans often offer better borrower terms than credit cards, that doesn’t make them the right choice for every situation.
If you need money for college, for example, federal student loans provide financing at a lower fixed interest rate than any personal loan would typically offer. Federal loans also offer borrower protections that personal loans don’t offer, including the ability to pause payments while in school or during periods of financial hardship.
More flexibility in repayment plans, the possibility of loan forgiveness for public service work, and the ability to claim a tax deduction for up to $2,500 in student loan interest are also important benefits you can’t get with personal loans.
Likewise, mortgages, home equity loans, and car loans could also be better options under appropriate circumstances. These loans can come with lower rates and -- in the case of mortgages or home equity loans -- could also provide a tax deduction for interest paid.
3. When you’re considering borrowing for a financial splurge
If you’re thinking about borrowing money for a vacation, a new wardrobe, or anything else you don’t really need, a personal loan can be a better way to borrow than a credit card -- but that doesn’t mean it’s a good idea to take one out.
Splurges on things that don’t increase your net worth in the long run are often a mistake unless you can afford to pay cash for them. While that vacation or big purchase may seem fun, you’ll significantly increase the cost of it by borrowing and paying interest. And during the years when you’re paying back what you borrowed, you’ll have less money available for financial goals or for other fun things.
Instead of borrowing money for new furniture, a fantastic trip, or other things you don’t really need, try saving up for them.
4. When you’re in over your head in debt already and don’t have a plan
One of the best reasons to take out a personal loan is to consolidate and refinance debt. You can use the proceeds from a personal loan to pay back multiple existing creditors, including credit card companies or medical loan servicers. This could allow you to lower the interest rate you were paying on existing debt -- assuming you get a personal loan at a low rate. It could also simplify repayment by giving you only one lender to pay back.
It’s not a good idea to take out a personal loan -- to repay debt or otherwise -- if you don’t have control over your spending and a solid plan to pay back your debt. If you transfer all your debt to a personal loan without a budget and the ability to live within your means, there’s a very good chance you’ll just end up charging up your credit cards again and owing on your cards and the loan.
You can’t borrow your way out of debt, so only take a personal loan to help with debt repayment if you’re committed to paying off the loan on time, living on what you earn, and not getting deeper in the hole.
5. If you’re not sure you can afford the monthly payments for the long haul
Personal loans are often structured so you take several years to pay them off. That means you need to make sure you’ll be able to afford to make the payments over the next few years.
If you’re worried you could lose your job next month or you’re planning on dropping everything and traveling the world in a year, you need to carefully consider whether you’ll be able to pay back your creditors over the long haul.
If you aren’t 100% confident you can pay back what you borrow in accordance with your loan agreement, you shouldn’t take out a personal loan. If you can’t make payments, you risk defaulting, damaging your credit, and getting a legal judgment against you.
Don’t get a personal loan if it doesn’t make financial sense
Before you take out a personal loan, be sure to consider whether you’ll be using the loan for a smart purpose -- such as repaying debt. And make sure that the loan will be affordable for you over the long term so you don’t end up defaulting and damaging your credit. If you’re smart about how you borrow, and you shop around for the most affordable personal loan lender, a personal loan can be a helpful tool rather than a financial burden.
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