Youâre in a pinch and in desperate need of money. Youâve already asked family members for help, but nobody can assist you. Youâve heard of a personal loan before, but is taking one out a good idea?
In short, it depends on your particular financial situation. If youâve racked up high-interest credit card debt, for example, and you can take out a personal loan with a lower interest rate to consolidate and pay off that debt, a personal loan might be right for you. But if you have other assets you can borrow against that will have lower interest rates â such as a 401(k) loan or a home equity line of credit (HELOC) â you might want to consider pursuing those lines of credit instead of a personal loan.
Hereâs everything you need to know about when a personal loan might be worthwhile, and when you might want to look elsewhere.
Personal loans can be taken out for a variety of reasons, such as to pay for car repairs or medical expenses, as well as to consolidate debt. Consider these ways you could use a personal loan.
Taking out a personal loan is particularly common for people who have significant high-interest credit card debt and are interested in consolidating that debt and paying it off. Personal loans can allow someone with high-interest credit card debt to take out a loan with a lower interest rate than their credit cards. Also, many consumers like having to make only one monthly payment.
If you explore personal loans in our marketplace, youâll find that they traditionally come with terms between 12 and 84 months.
Charles Adi, a financial advisor with Blueprint 360 in Houston, said the most common reason he advises his clients to take out personal loans is for the consolidation of high-interest credit card debt â particularly when the interest rates on clientsâ credit cards are more than 15 percent.
âBecause on the personal loan side, youâre probably looking at a 7 to 9 percent interest rate, so that savings is very helpful,â Adi said. (This rate, it should be noted, is likely for borrowers with excellent credit.)
In August 2018, the average interest rate on personal loans for people with excellent credit (760 and above) was 8.10 percent, according to data from our parent company, LendingTree. For those with good credit (680 to 719), it was 17.92 percent.
Josh Nelson, a certified financial planner and the CEO and founder of Keystone Financial Services in Fort Collins, Colo., said one benefit of using personal loans for the consolidation of high-interest credit card debt is that they push clients to begin using better financial habits.
âThe nice thing about a consolidation loan is that it does force discipline,â Nelson said. âIt forces people to have to make that higher monthly payment.â
In addition, Adi said many of his clients like the one monthly payment that accompanies a debt consolidation loan. âA lot of my clients get frustrated when they have to keep track of five or six different cards,â he said. âConsolidating it into one payment and [seeing] that balance going down steadily â itâs just a feel-good story.â
He adds that he doesnât recommend clients take out personal loans for debt consolidation if they donât have good financial habits already in place. He said he has seen a handful of times where clients take out a personal loan to pay off high-interest credit card debt, and then spend the personal loan on their lifestyle.
âThatâs pretty much the only time where I donât move forward with it because it makes no sense helping someone save a few thousand on interest if itâs going to lead to them making poor financial decisions,â Adi said.
Taking out a personal loan for home repairs only makes sense if youâre disciplined enough to pay off the loan quickly. It can also make sense if youâre going to refinance your home to pay off the personal loan.
Although many homeowners will make repairs or renovations using a HELOC, some will also take out a personal loan if they are unable to take out a home equity loan because they donât have enough equity to qualify for a HELOC. âIâve recommended [personal loans] for individuals who wanted to do some home repairs, but they couldnât access money from their house via the traditional equity channels,â Adi said.
But Luis Rosa, a certified financial planner with Build a Better Financial Future in Henderson, Nev., said most consumers looking to make home repairs will consider a HELOC before a personal loan.
âTypically, the home equity loan is going to be a lower interest rate than a personal loan because you have the home as collateral,â Rosa said. But consumers who take out a HELOC only get charged for interest as they use the credit line.
âIf you needed a $30,000 home improvement project, you might draw $5,000 at a time, as opposed to the personal loan, where you get the whole $30,000 upfront and start paying interest on the full amount,â Rosa said.
Jeff Motske, a certified financial planner and president of Trilogy Financial in Southern California, said he has seen people use personal loans in real estate. For example, he had a client whose house was still in escrow, but the client wanted to buy a home in 30 days.
âThose are opportunities to get personal bridge loans to manage that gap and not have to deal with running a whole new mortgage you want to pay off because youâre moving into retirement or you donât want debt on the house,â Motske said.
Ilene Davis, a certified financial planner based in Melbourne, Fla., said she rarely advises clients to pursue personal loans because of their high interest rates. In fact, one of the only situations in which she would recommend clients use them is for a bridge loan in which the client will only need the money for a short period and has the resources to pay it back quickly.
Although itâs not ideal, Rosa said he has seen people take out a personal loan to finance a large purchase, such as an engagement ring or wedding. âYou probably donât want to buy a big-ticket item like that on credit, but Iâve seen people do that just because it was cheaper than credit cards,â he said. This only makes sense if you have excellent credit and can repay the loan back quickly.
Also, Rosa said he has seen people take out personal loans to pay for medical procedures. âIf youâve considered the alternative of financing through the doctorâs office or if that was not an option, then perhaps it makes sense because it would be cheaper than putting it on a credit card,â he said.
A personal loan can be a great way to manage your debt or afford purchases. But weigh your options carefully. Taking on debt is a long-term decision â and you may have other options to consider.
Dennis Nolte, a certified financial planner with Seacoast Investment Services in Oviedo, Fla., said he typically recommends clients borrow against their own assets, such as their home, before pursuing a personal loan.
âBecause [personal loans] are so expensive, and you have to jump through hoops to qualify, we try to find where they have assets and borrow against those assets first,â he said, adding that a HELOC is not as common as it used to be because the new tax law doesnât allow deductions if the funds arenât being used for real estate. âBut most people who are going for a personal loan probably arenât itemizing anyways,â he said.
Motske said he recommends a HELOC over both a 401(k) loan and a personal loan nearly every time.
âIn particular, if itâs just a short-term or a manageable piece, because a home equity line usually has some tax benefits next to it, whereas personal loans and credit card loans not only donât have those benefits, but also they come at much higher interest rates,â he said.
Nolte said that despite the common lore that you should never borrow against your 401(k), it might be the last resort for young people whose only savings are in their retirement accounts. Nolte said the benefits of taking out a 401(k) loan over a personal loan are that you donât have to qualify, youâre paying yourself back in interest and itâs your money.
âBasically, itâs your assets,â Nolte said. âIf youâre just shifting assets on a balance sheet and youâre disciplined about it, thatâs not a bad way to go. Rather than going to other sources that are going to charge you a lot more interest, a lot of times it makes sense to use your existing assets if you can.â
Sallie Mullins Thompson, a certified public accountant and financial planner based in New York City, said that although taking out a 401(k) loan is fine, people have to be extremely careful that they follow the guidelines set in place for paying it back.
You have to pay the loan back monthly, you have to pay it back within five years, you canât get another loan on that 401(k) and if you leave the company before the loan is paid back, there are ramifications: The entire loan has to be paid back immediately, and, if it isnât, youâre liable for the income tax on it as well as the 10 percent penalty if youâre under 59 Â˝, Thompson said.
âPlus, thereâs the fact that youâre taking money from your retirement investment thatâs no longer earning money,â she said. âAnd then youâre paying it back with interest.â
Adi has also recommended that his clients take out 401(k) loans in the past. âDepending on what the rates are, you could probably hit a 5 percent rate on a loan from a 401(k), and that interest is going back to yourself,â he said.
Be cautious of the idea that youâre âpaying yourself back,â Mostke said.
âYouâre really not,â Motske said. âYouâre hurting your ability to grow that nest egg that youâre going to need for retirement.â
Thompson said, typically speaking, itâs not wise to use a personal loan to consolidate and pay back student loan debt.
âThe personal loan rates are usually under credit card debt rates, but they would not be under student loan debt rates, particularly with the various repayment programs you find these days,â she said.
Rosa said he doesnât advise his clients to use personal loans for student loan debt either. âThere are companies that do debt consolidation loans specifically for student loans, and you can do them through the government as well,â he said. âYou can actually just consolidate it through studentaid.ed.gov, so you wouldnât need to go to an outside lender for that.â
You might be able to secure a better personal loan interest rate through a credit union. Adi said he often advises his clients to look for personal loans at credit unions or even local banks because they tend to have better rates than larger institutions. If you already have a loan at the institution, thatâs even better.
âLetâs say you have your car at a local regional bank, go back to the same institution looking for the personal loan as opposed to going somewhere else, because you want to have that history with the bank so that the next time you come back, youâre a preferred customer,â Adi said.
And if you have two financial products open with an institution, such as a car loan and a mortgage, youâll be in even better shape. âTry to accumulate goodwill with the particular institution if possible,â Adi said.
Nolte said he advises his clients to look for personal loans at credit unions, too. âFor interest rates on loans, they are generally cheaper, and they work with you a little bit more than some of the bigger banks,â he said.
And while credit unions used to have strict membership requirements to join, they may be more lenient nowadays, Nolte added.
If youâre shopping for a personal loan online, youâll likely be submitting to soft credit checks, which donât affect your credit. But if you find lenders that require a hard credit check each time you request a quote, that could hurt your score.
Regular on-time payment on a personal loan can boost your credit score, as it shows that you responsibly manage and pay back your debt.
One thing to be cautious of is taking out a personal loan for credit card debt consolidation, and then closing old credit cards. Rosa said consumers will often take out a personal loan and then close all their credit cards because they feel like they need a fresh start.
âBut that might hurt them creditwise, because they might pay off a card that theyâve had for a very long time, which has helped them build that credit history,â he said. In addition, some people will open a new credit card at the maximum limit while they are still paying back their personal loan, which can lower oneâs credit score, according to Rosa.
When shopping for a personal loan, there are a few common pitfalls you should avoid.
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