The Pros And Cons Of Personal Loans: What To Consider

Personal loans are a type of installment loan that can help borrowers cover a wide range of expenses. Making large purchases, consolidating credit card debt and paying for home improvements are common reasons for using this type of financing.

Before you decide whether to pursue this option, let’s check out the pros and cons of personal loans along with some other considerations worth taking into account.

Before we take a deep dive into the advantages and disadvantages of a personal loan, here’s a brief overview.

Compared to credit cards, personal lines of credit, home equity loans and short-term loans, personal loans come with several pros, as highlighted above. Now for a closer look at them.

1. Consistent Monthly Payments

Unlike credit cards or other lines of revolving credit, personal loans typically use a fixed interest rate. That means the interest rate you secure when you’re approved for the loan stays the same over the repayment period. Your monthly payment amount will be consistent since your rate is fixed, making it easier to budget.

2. Wide Variety Of Uses

Another advantage of a personal loan is the numerous ways you can use it. In other words, your lender won’t care how you spend the lump sum as long as it’s not for nefarious purposes.

Personal loan funds can be used for:

• Home improvements
• Emergency expenses
• Debt consolidation
• Wedding costs
• Large purchases

However, being able to use a personal loan for almost anything you wish doesn’t mean you should. Personal loans are typically best for situations where you know the exact amount of money you’ll need to borrow and you’re confident you can afford the monthly payments.

3. Competitive Interest Rates

If you have good credit, you could enjoy a lower interest rate with a personal loan. Other types of financing, like credit cards, title loans and payday loans, usually carry a much higher rate. For instance, according to the Federal Reserve, the average annual percentage rate (APR) for a 24-month personal loan was 10.16% in the third quarter of 2022, while a credit card’s average APR was 16.27%.

4. A Low Chance Of Needing Collateral

Personal loans come in two forms: secured and unsecured. A secured loan requires collateral, while an unsecured loan doesn’t. Unsecured personal loans are the more common option and are a popular alternative to various forms of secured financing, including home equity loans and home equity lines of credit (HELOC).

5. Longer Loan Terms

The average repayment term for a personal loan is 12 – 60 months, but some lenders may offer more or less time, depending on your situation. Most short-term loans, like payday loans or title loans, only last 2 – 4 weeks. A longer term means the monthly payment for a personal loan would be significantly smaller than the amount you’d pay back all at once for a short-term loan of the same amount. That’s because the payments are spread over a lengthier time period.

6. Shorter Funding Timeframe

The application period for a personal loan is relatively short. Some lenders and lending platforms, including Rocket Loans^SM, even offer same-day funding to qualifying borrowers.* This feature makes personal loans a great option if you need to cover an unexpected medical bill or emergency car repair.

While it can be easy to focus on the benefits of personal loans, it’s important to understand the drawbacks as well. Let’s take a closer look at some of the cons of using a personal loan.

1. Strict Credit Score Requirements

Since most lenders have a minimum credit score requirement in the mid-600s, a personal loan might not be the right option if your credit history is less than optimal. Of course, you may be able to qualify with a lower credit score if you choose a secured option or use a co-signer. But keep in mind: Not all lenders offer co-signed loans or accept collateral.

2. High Interest Rates

If your credit score is just high enough to be approved for a personal loan but still considered relatively low, you probably won’t land a good interest rate. The interest rate on a personal loan can be as high as 36%, meaning you’ll pay a substantial amount of interest over the repayment term. This is why some borrowers may benefit from improving their FICO® Score ahead of time or using another option altogether.

3. Increased Debt Obligations

When you apply for any type of loan, the lender will calculate your debt-to-income ratio (DTI), which is a comparison of your gross monthly income and monthly debt payments. Installment loans are included in this calculation, so a personal loan will increase your DTI. You might not think this is an issue, but a higher DTI could make it hard for you to be approved for another loan.

For example, let’s say you’re planning to purchase a home in the near future but you’ve recently taken out a personal loan – and when you apply for a mortgage, the lender determines that your DTI is over 43%. In this case, the personal loan could prevent you from getting a mortgage. However, you can reduce your DTI by paying off your debts or increasing your income.

4. Extra Fees And Penalties

Even with a low interest rate, personal loans can be costly. Most lenders will charge borrowers a loan application fee – sometimes called an origination fee – that helps cover the administrative costs of processing the loan. If you don’t make on-time payments, your lender might also charge a late fee. Some lenders even issue a prepayment penalty if you pay off the loan early.

5. Possible Collateral Requirement

As mentioned, if you plan on using a secured personal loan, you’ll need to provide collateral. For collateral, lenders may accept one of a wide variety of items that include a car, a boat, a certificate of deposit (CD) and a savings account. If you don’t pay back the loan, the lender can claim the property as their own.

6. Potential Financial Risks

Missing or making late loan payments could negatively affect your credit in several ways. Defaulting on a personal loan will significantly reduce your credit score and show up as a negative mark on your credit report for as long as 7 years.

If you use an unsecured loan, your lender might take you to court where a judge could decide to garnish your wages until the loan is paid in full. With a secured option, your lender might recoup their losses by repossessing the item you used as collateral.

In either case, your lender could also sell your debt to a collection agency. But no matter which scenario unfolds, your personal finances will feel the negative effects if you fall behind on payments, completely stop paying or default.

If you’re unsure whether the advantages of a personal loan outweigh the disadvantages, you can learn more by reviewing the answers to these frequently asked questions.

How can I tell if a personal loan is right for me?

Personal loans are a great way to fill a temporary gap in your budget, but not everyone should use this type of financing. If you’re confident about the amount you’ll need to borrow and that you can pay back the loan on time, a personal loan could work for you. However, if you have a tight monthly budget or feel unsure about the loan amount you’ll need, you might want to consider other options.

What are the eligibility requirements for a personal loan?

Most lenders require a minimum credit score in the mid-600s and a maximum DTI of 36% – 50%. If you don’t meet either of these requirements, you can work on improving your credit score before applying. This not only helps you secure approval, but you’ll likely get a better interest rate and longer loan term.

What should I consider before taking out a personal loan?

Like any type of financing, personal loans necessitate taking a few factors into consideration before moving forward. While researching your options, ask yourself these questions:

• Loan amount: “Do I know how much I’ll need to borrow?” If not, you might need a line of credit instead of an installment loan.
• Monthly payment: “How much can I afford?” If you don’t have room in your budget for another payment, you might need to hold off on pursuing a personal loan.
• Credit score: “What is my credit score?” Make sure your credit score is high enough to land an interest rate that fits your budget.

Personal loans can be helpful for several reasons, but they also come with a few risks. That’s why it’s essential to understand the pros and cons of getting a personal loan and all the factors you should consider before making a decision on this option.

If you’re ready to apply for a personal loan, you can get started today with Rocket Loans.

*Same-day funding is available for clients completing the loan process and signing the Promissory Note by 1:00 p.m. ET on a business day. Also note, the ACH credit will be submitted to your bank the same business day. This may result in same day funding, but results may vary, and your bank may have rules that limit our ability to credit your account. We are not responsible for delays that may occur due to an incorrect routing number, an incorrect account number or errors of your financial institution.