Personal loan pros and cons

Rising inflation can make it difficult to pay cash for large purchases or even stay on top of everyday expenses. And with the average credit card interest rate sitting at 22.59% APR, carrying credit card debt can be costly.

A personal loan may be a better solution. The average rate on a two-year personal loan is 12.49% APR, according to the Federal Reserve, which could save you hundreds or thousands of dollars in interest compared to using a card. And payments are usually fixed — which means they won’t increase if rates do.

What are the benefits of a personal loan?

In general, personal loans offer unmatched flexibility and have very few restrictions on how they can be used. You can use a personal loan for almost anything you can use a credit card for — to consolidate high-interest debts, pay for medical expenses, make home improvements, cover emergencies, and more. And you can often do it at a lower rate compared to using a card.

Plus, you can select a repayment term, typically between one and seven years, depending on the lender and loan’s purpose; and you can receive money within days of applying, in most cases. And since personal loans are typically unsecured, they don’t require collateral. You can also find lenders that have little to no fees, like LightStream or PenFed.

Personal loan pros

Limited restrictions

What to know: Personal loans can fund a variety of expenses from consolidating debt to home renovations.

When you take out student loans, a mortgage, or an auto loan, the funds must be used for a specific purpose — for example, your education, home, or a vehicle. Personal loans have very few restrictions and can be used for many things. So whether you’re looking to consolidate debt, pay for medical expenses, or finance a home renovation or a wedding, personal loans are an option.

The “personal” in personal loans provides flexibility in how you use the funds. While you can use personal loans for most things, typically you can’t use the funds for a down payment, tuition costs, or business expenses.

Flexible terms

What to know: Personal loans offer years-long repayment terms so you can fund a large expense and pay it back in affordable monthly payments over time.

Personal loans offer a wide range of repayment terms and loan amounts to choose from. Plus, funding is quick. You typically receive funds between one to five business days of being approved for a personal loan and may be able to qualify for up to $100,000 or more, with select lenders. Receiving funds upfront in a lump sum allows you to pay for expenses over two to seven years, in most cases, which can make even large expenses fit your budget.

Personal loans are typically unsecured loans, meaning you won’t have to put up collateral. It’s also why some lenders can approve your loan the same day you apply (no need to appraise the value of collateral).

Like most loan products, approval hinges, in part, on your credit. But even if you have bad credit, you may still qualify for a personal loan, especially if you choose a lender that specializes in loans for bad credit. Keep in mind, your interest rate will likely be higher than most borrowers with fair to good credit.

Fixed monthly payment

What to know: Personal loans typically come with fixed interest rates, so your monthly payment won’t change over time.

Whenever you take out a loan, you’re adding a monthly payment to your household budget. Personal loans are appealing as they typically come with a fixed interest that doesn’t change.

Because of that, your monthly payments are fixed, too. This kind of predictability can make it easier to budget for repayment and help limit surprises.

Fast financing

What to know: Personal loans typically payout within a few business days of approval. In some cases, you may be able to receive your funds the same day you apply.

At some point, you might need extra cash to help pay for an unexpected or planned expense. Personal loans not only offer flexibility in how the funds are used, but they also can provide fast financing.

After you apply for a personal loan and are approved, the lender will typically transfer a lump sum into your bank account. If you're using the loan to consolidate debt, many lenders will send funds directly to your creditors and may offer a rate discount to do so. Some personal loan lenders send the funds as soon as the same business day you’re approved, as long as your application is submitted by the lender’s cutoff time.

Lower APR than credit cards

What to know: Based on Fed data, the average APR for a credit card was 21.59%. By comparison, the average APR for a 24-month personal loan was significantly lower at 12.49%.

Borrowing money means paying interest. How much your total interest costs are will depend on the size of the loan as well as the annual percentage rate (APR) you’re approved for.

If you have good to excellent credit, personal loans may provide a lower APR than credit cards. Even if you have fair or bad credit, you might qualify for a lower rate. But your APR depends on the repayment term you choose, as well as other factors, like your income and current debt-to-income ratio (DTI).

The average personal loan APR for a 24-month loan was 12.49%, according to Fed data. But here’s what it could be for three- and five-year term loans for different credit profiles:

Before you apply for a personal loan, you can typically prequalify on the lender’s website or a personal loans marketplace to see your potential rates with one or more lenders. This won’t hurt your credit score, but the rate isn’t guaranteed. You’ll also need to agree to a hard credit pull when you apply, which could temporarily ding your score by a few points.

Build credit

What to know: Personal loans can help improve and build your credit if you maintain on-time and in-full payments.

Personal loans are a type of installment loan. If you don’t have another installment loan like a mortgage or student loan, taking out a personal loan can help your credit mix which makes up 10% of your credit score.

More importantly, keeping up with your monthly payments and paying on time can elevate your credit score, as payment history makes up the largest share of your credit score at 35%. Plus, if you use a personal loan to consolidate credit card debt, you can decrease your credit utilization — which can contribute up to 30% of your score — almost overnight. This can result in a rapid credit score boost, as long as you keep those accounts open.

Personal loan cons

Increase DTI

What to know: Personal loans can increase your DTI. If your DTI is too high, you may not qualify for other lending opportunities like a mortgage or auto loan.

If you’re taking out a personal loan, you might just be thinking of solving the immediate problem at hand. But it’s important to think long-term as well. One of the cons of personal loans is that it increases your DTI.

Your DTI is a metric that expresses the percentage of your income that is used for monthly debt payments. It’s determined by adding up all of your debt payments and dividing that sum by your gross income. It’s often used by lenders to assess your financial health. If your DTI is high, lenders may be less willing to lend to you, making it tougher to get a mortgage or auto loan.

A healthy DTI is generally below 36%. Some lenders may allow a DTI of up to 50%, but beyond that, you may be considered a risk if too much of your income is going toward debt.

Credit damage due to missed payments

What to know: If you miss your payments on your personal loan, you can damage your credit and may not qualify for other loans.

One of the keys to maintaining a healthy credit score is making all of your payments on-time and in-full. If you sign up for a personal loan with terms that are outside of your budget, you have the potential to miss payments and damage your credit score.

Damaging your credit score can lead to a host of other issues like losing access to higher credit limits or not being able to apply for other loans like a mortgage or auto loan.

To avoid damage, find a personal loan lender with repayment terms that fit your monthly budget. It is better to have a higher interest rate with doable fees than to miss payments and damage your credit.

Fees and penalties

What to know: Personal loans may have upfront fees, like an origination fee, plus late fees and penalties.

When researching personal loans, consider fees and penalties. Some lenders charge an origination fee, which is an administrative cost deducted from the loan amount to cover processing your loan application and to minimize the lender’s risk.

Origination fees are expressed as a percentage of the loan amount, and can range from 1% to 12% of your total loan amount.

For example, if you took out a $10,000 personal loan with a 3% origination fee, you’d pay a loan origination fee of $300. So in this case, you’d receive $9,700.

Fortunately, the loan’s APR accounts for upfront costs like an origination fee, in addition to the loan’s interest rate. This is why it’s a better way to compare total loan costs between lenders than comparing interest rates alone. Aside from origination fees, lenders may charge late fees and insufficient funds fees. We’re not aware of any lenders with prepayment penalties in place, but it’s a good idea to closely review all mandatory and potential loan fees before signing the loan agreement.

Interest

What to know: If you only qualify for unsecured personal loans with high interest rates, you may want to consider other loan options, like a home equity loan or a secured personal loan.

As a borrower, you pay interest to the lender in exchange for the convenience and ability to borrow money. While personal loans may have lower APRs for consumers with a solid credit profile, not everyone will qualify for the most competitive rates.

Personal loan APRs could be up to 36% with traditional lenders, and even higher via emergency lenders. It may not make sense to use a personal loan if you can qualify for a lower rate via a secured loan, like a home equity loan, home equity line of credit, or even a cash-out auto loan refinance.

But it’s important to keep in mind that personal loans, unlike credit cards, don’t charge compounding interest (interest on unpaid interest) — which can make them a good choice for credit card consolidation even if you don’t qualify for a lower rate.

Strict eligibility requirements

What to know: Personal loan lenders have minimum requirements to qualify for funding, including minimum credit score and income requirements.

Though personal loans offer flexibility and convenience, you’ll still need to meet the lender’s criteria to get approved for a personal loan. Some lenders have strict eligibility requirements, while others don’t. For example, here are common eligibility requirements::

• Minimum credit score: Axos requires a FICO score of 730 or higher, while OneMain Financial has no credit score minimum.
• Maximum DTI: While many lenders prefer a DTI below 36%, Upstart will consider applicants with a DTI as high as 45% to 50%.
• Minimum income: Achieve requires an income of $80,000 per year, while Discover requires a minimum household income of $25,000.
• Regular employment: Some lenders may require that you’re employed full-time, while others may accept alternative sources of income, such as unemployment benefits, passive income, and Social Security. .

Lenders vet you as a borrower to see if you’re a good candidate to pay back the loan before approving your application. While many lenders consider the same things, each has its own minimum eligibility requirements.

Minimum payment options unavailable

What to know: Unlike credit cards, personal loans rarely offer the option to pay less than the agreed-upon monthly payment amount.

Personal loans typically have a fixed rate, resulting in fixed monthly payments. This type of predictability can make planning and budgeting easy — but may not work if you lose your job or the income you rely on to make payments.

Review your budget carefully and consider if an added and inflexible monthly payment is reasonable. Is your income likely to drop within the loan’s term? Would you benefit from having a minimum payment option, like on a credit card? Use a loan calculator to compare monthly payments and total interest for different loan terms and types.

Is a personal loan right for you?

Use the following questions as a starting point to determine whether a personal loan is the right move for you.

How to apply for a personal loan

1. Check your credit

Start the process for finding a personal loan by checking your credit score and assessing your qualifications. A higher credit score will give you a better chance of getting approved for a loan with a lower interest rate.

FICO credit score ranges:

• Poor: 300-579
• Fair: 580-669
• Good: 670-739
• Very Good: 740-799
• Excellent: 800+

2. Research lenders

You can find personal loans through online lenders, banks, and credit unions. Research and compare lenders based on their terms, funding time, loan amount, and credit score and income requirements to find the best fit for you.

3. Prequalify

Most online lenders let you prequalify to see what your rates and terms could be. Prequalification is typically free, available via most lenders, and does not require a hard credit check (so it won’t hurt your credit score). Keep in mind that prequalification is not a guarantee of terms, but rather an estimate.

4. Select your lender and apply

Once you find the lender that’s right for you, gather the documents necessary and apply. Lenders will typically require proof of income, proof of identity, and your Social Security number.

5. Read the fine print and sign

Once you receive your offer, review the terms and conditions with a fine-tooth comb. If the agreement looks good and fits your monthly budget, sign to receive funding.

How to find the best personal loan

The best personal loan is going to be the one that fits into your monthly budget and has the best rates and repayment terms. If you are trying to find the right lender for your financial situation consider the following:

• Credit score requirements: Most lenders have a minimum score requirement to be able to qualify for funding. Check lender requirements to see if you’ll meet the threshold.
• Loan amounts and repayment term availability: You can get funding with a personal loan up to $100,000 or more, depending on the lender and what you can qualify for. If you need a small personal loan, make sure the lender’s minimum loan amount meets your needs.
• Funding time: Most lenders send the funds in one to five business days of loan approval.
• Co-signed, joint, and secured loan availability: Some lenders will allow you to use a co-signer on a loan. Opting for a co-signed loan could help you qualify or get a lower rate.

Personal loan alternatives

After reviewing personal loan pros and cons, you may realize that it’s not the best option for you. Here are some personal loan alternatives to consider.

Line of credit

You may be able to access a personal line of credit through your bank with more favorable rates.

Credit card

If you have excellent credit, see if you qualify for a 0% APR credit card. Just be aware that the 0% is for a set promotional period, such as up to 21 months, and adjusts to the card’s standard rate after that time.

Home equity loan

Homeowners with at least 20% of equity may be able to use it to score a home equity loan. Your home is used as collateral, which means if you fail to make payments your home can be taken through foreclosure.

Credit builder loan

A credit builder loan can help you improve your credit and start saving. You’re loaned the money, which goes into an account you can’t access, and you make monthly payments for the term of the loan. Only after you pay off the loan can you access the funds.

Savings account

If you have funds available in your savings account to cover your costs, you can avoid paying interest and fees. But be careful — it’s often wise to maintain at least three to six months’ of living expenses in an emergency fund. Opting for a loan is often better than depleting an emergency fund.

Payday alternative loan

Some federal credit unions offer payday alternative loans or PALs to borrowers with poor credit. A PAL can provide funds up to $2,000 at a rate no higher than 28% for a term up to 12 months to credit union members.

Family and friends

If a personal loan doesn’t work for you, look to borrow the funds from family or friends. This process can be tricky, so come to an agreement and lay out the terms in writing for repayment.

FAQ

Do personal loans hurt your credit?

Taking out a personal loan and paying it back on time can help your credit mix and payment history, which benefits your credit score. However, applying for a personal loan can result in a slightly lower score due to a hard inquiry. Additionally, if you miss or make late payments on your personal loan, your credit score will be negatively impacted.

What can you use a personal loan for?

A personal loan differs from many other types of loans as it can be used for a variety of reasons. It’s for your personal use, which could mean the loan covers an emergency, a vacation, a home renovation, or debt consolidation. But it’s important to only use the loan for the purpose you state on the application - otherwise, the lender could require payment in full, immediately.

What is a good interest rate on a personal loan?

Every lender offers a range of interest rates on their personal loans. For example, you may be able to qualify for a personal loan with Upstart at an interest rate as low as 7.8%. However, it’s more likely that a good rate will be higher than that for most borrowers. Scoring the best rate will depend on your credit score and if you meet the qualifications of the lender.

What happens if you pay off a personal loan early?

Paying off a personal loan early is a no-fee option with most lenders. While it’s important to check your loan agreement for a prepayment penalty, few if any lenders charge this fee.

Can I go to jail for not paying a personal loan?

You can’t go to jail for not paying a personal loan, but you could see some jail time for a related issue. For example, if you are sued, are ordered to make a court appearance, and don’t show up, you can have a warrant put out for your arrest.

Is a personal loan better than credit card debt?

Whether a personal loan is better than a credit card depends on the terms and conditions of the loan, including the monthly payment amount and the loan’s APR. If you can qualify for lower rates with a personal loan than a credit card then a personal loan is likely better than a credit card.