If you are in tight financial spot – you’re probably looking at any and all sources of fast cash. Among those options are personal loans.
But what is a personal loan? Where can you get such loans? And are they a good idea or a treacherous financial trap?
Below, I’m going to answer these questions and more. Let’s start out with the basics.
What is a personal loan?
A personal loan is a money you borrow for any personal use other use other than to finance a business or real estate.
You can get these loans from banks, credit unions or online lenders. You can even arrange such loans from friends and family.
The thing to keep in mind is that these loans are usually arranged to be paid back with monthly payments over 2 to 5 years.
In most cases, these loans are fully amortized – that means your fixed monthly payment includes interest and principal.
Most personal loans are unsecured. That means the lender advances you the money based on your credit history and doesn’t have any asset to back it up in case you fail to make your payments.
This last part about the loans being unsecured is a very important piece of the puzzle. Why?
Because, since the lender doesn’t have an asset to fall back on in case you flake out, they take on more risk.
And since the lender takes on more risk, they charge you higher (sometimes MUCH higher) interest rates when you take out a personal loan.
Is it smart to take out a personal loan?
I’m going to let you answer that one yourself by asking you 4 questions:
- Are you using the money for a smart financial purpose?
- If you are using this money to pay off or consolidate other debt, is the rate lower on the personal loan than the rate on the existing debt?
- Is this the cheapest/least risk alternative to get the money?
- Can you afford to make the payments?
If you answer “yes” to all the above, then it is probably a smart move to take out the personal loan.
If you answer “no” to any of the three questions, slow down and think again before going forward.
Let’s break these questions down to get a better handle on the question.
Are you using the money for a smart financial purpose?
Assuming you are not using the money to refinance other existing debt, think hard about why you need this personal loan.
Is it to satisfy a need (medical procedure or make a necessary repair like fix the roof) or a want (elective surgery, vacation, elective house remodel, private school)?
If it’s a need – and I mean really something you absolutely can’t live without doing – then the answer is, “yes”, you are probably using the money for a smart financial purpose.
If you are using the money to satisfy a want, then maybe it’s not the smartest move.
The big problem with borrowing money (no matter how cheap it is) to pay for wants is that, if you are like most people I know, the “wants” list constantly expands.
Do you know anybody who has everything they want? I don’t.
If you allow yourself to get into the habit of taking out loans to pay for something you want but don’t really need, you run the risk of getting hooked on that easy money habit and that can mean you’ll find yourself constantly in debt. And nobody ever achieved financial success by staying in debt.
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Are you using the money to pay off other higher-cost debt?
This question is pretty straight-forward and easy to answer.
Either the existing debt costs more than the proposed personal loan or it isn’t.
If it isn’t, don’t do it. Debt consolidation is cool I guess. But if the consolidation doesn’t reduce the interest rate it’s a bad move because you increase your costs by doing so.
If you really want to consolidate your debt because you want to simplify your life and have one rather than several payments to make each month, it might be ok. But only if the rate is lower or (at worst) the same as your currently paying.
If the consolidated debt offer is higher than what you currently pay, just stick with your current creditors and put them on auto bill pay.
You can simplify your life without spending more money. You can thank me later.
Is the personal loan the cheapest source of funds?
Companies who provide personal loans make a lot of money doing so because the rate they charge is high as I said before.
Since they can’t compete on price they try to compete on convenience. In other words, they can get you your money pretty quickly.
But keep in mind that the faster a lender makes funds available, the more expensive those loans can be.
That being the case, if you find yourself in a situation where you might need a personal loan, try to start this process as early as possible.
That way you won’t be forced to take the first offer that comes around.
In fact, if you plan early enough, you might find alternative and lower-cost options. How about refinancing your home?
If that isn’t an option, have you considered going to friends and family? I know on the face of it, this can sound like a very bad idea. But with the right approach, this could turn out to be the best way to go.
Even if it isn’t, make sure you consider all your options (including delaying or canceling the project until you have the money yourself).
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Can you afford to make the payments?
As I said near the start, when you take out a personal loan, the payments and time period is fixed. At the end of that period, your loan will be repaid – assuming you make all your payments on a timely manner.
If you miss payments, you’ll be in a world of hurt. Among other problems, your credit score will suffer big time and that will make it harder and more expensive to borrow money in the future. And that’s just the good news.
If you crash your credit score hard enough (by missing more payments or heaven forbid defaulting on your personal loan) you may find it more difficult to find a job, rent a place, get a mortgage or get life insurance.
In other words, if you mess up here, you could open the door to big financial difficulties down the road.
This is the reason why I’m a firm believer in NOT borrowing money (again, no matter how cheap it is) unless you really truly need it.
A personal loan can be a great financial tool if used wisely.
Make sure you are using the money for a good reason, the rate is lower than existing debt, it’s the lowest cost alternative and you can afford to make your monthly payments over the time period you have obligated yourself to.
If you do, it’s highly likely that a personal loan is a good move.
Wired says
I think they can be a useful tool if used correctly. Do your research, there are a ton of companies out there. There are only a few that offer low interest rates.
Neal Frankle, CFP ® says
So true. What hasbeen your experience?