A lifeline — that is the main benefit of obtaining a personal loan. In the United States, almost a quarter of the adult population have taken out such a loan. But why do so many people do that? The answer is diverse since personal loans are versatile financial tools.
What Is a Personal Loan?
Personal loans are money borrowed from a bank or credit union used for many purposes. Some people, for example, use it for consolidating debt. Others may use it on a home improvement project, cover unexpected expenses, or make large purchases.
The repayment terms for personal loans are negotiable. In most cases, it can be from 12 to 60 months. Because paying off the debt is through monthly repayments, you can consider a personal loan as a form of installment loan. Read more about installment loans for bad credits.
All personal loans come with expenses:
- Interest charges
- Other fees, such as but not limited to:
- Application fee
- Processing fee
- Origination fee
- Prepayment penalties (if you pay the principal in one lump sum ahead of the terms)
Interest Rate vs. Annual Percentage Rate (APR)
As alluded to, you are paying not only for the interest but also loan fees. Most people, in particular, focus only on the interest rate. But doing that is a mistake. Unfortunately, some lenders advertise lower interest rates to entice customers. Unknown to borrowers, they also get charged higher than industry average loan-associated fees.
To solve this problem, reputable lenders use the APR as a measure. In simple terms, APR is the cost of borrowing money that includes the interest and all other fees. Although it is not perfect, APR does provide a more accurate representation of the cost of obtaining a loan.
APR makes it easy to shop around for the best deals as it takes away almost any possibility of hidden fees.
Secured vs. Unsecured Personal Loans
A secured personal loan means you put up collateral to guarantee that you will repay the entire loan. Among the most common collaterals are cars and houses.
Compared to unsecured loans, secured loans pose fewer risks to the lender, which is why the interest rate is lower. While it is easier to obtain approval, you also risk losing the collateral when defaulting on loan payments.
Most personal loans, at any rate, are typically unsecured. Without collateral, there is nothing to seize. Because it is riskier to lenders, you can expect higher interest rates.
Ultimately, choosing between a secured or unsecured personal loan comes down to your financial situation and confidence level. Is an unsecured loan with higher interest acceptable? Or, do you choose secured loans that require collateral but have a lower interest rate?
Why Get a Personal Loan?
Personal loans are the fastest-growing niche in the consumer debt market over the last decade. In 2020, the total personal loan debt reached $323B. Even so, it represents only 0.9% of the outstanding consumer debt. So, how did people spend this money?
Table 1. Top Reasons Why People Get Personal Loans
|Start a business
|Pay medical expenses
|Help a family member
|Pay for a vacation
|Pay for gifts
|Pay legal fees
|Pay for a wedding
|Pay for a funeral
As you can see, the reasons are diverse but let’s dive deeper into the details of some of the top reasons.
1. Debt Consolidation
By far, more people use a personal loan to consolidate high-interest debt such as credit cards. In the USA, the number of credit cards per person is almost 4, with 79% of the population owning at least one.
As many have figured out, exchanging high-interest debts with a lower one can save hundreds or thousands of dollars. It is also easier to manage one fixed monthly payment instead of dealing with multiple credit card balances. As of May 2021, the Federal Reserve reports that the average interest rate is 16.3%.
But not all rates are the same. Aside from the market condition, the credit score is also another factor – and a huge one at that. Lenders charge higher interest rates on accounts with poor credit history. In addition, there are also other fees to consider.
APR, which includes interest and all other fees, is better for measuring credit card or loan charges. As of July 2021, the average APR of credit cards is 20.25%.
For personal loans, the APR ranges from 3.99% to 35.99%. As of June 2021, the average APR is 10.38%. And, this rate should remain relatively stable until at least 2022.
As you can see, the difference between paying 20.25% for credit cards and 10.38% for a personal loan is massive. In simple terms, you can cut down how much money you are paying for APR by half. Because many unsecured personal loans have fixed interest rates, you are effectively locking down the lower rate even if it increases. Hence, it is no wonder that most people use a personal loan to consolidate debt.
2. Start a Business
When talking about the reasons why people take out a personal loan, most overlook starting a business. That is because some lenders have a restriction on its use for such purposes. Instead of a personal loan, the more suitable loan type is a business loan.
But not all people can meet the requirements of business loans. Hence, if there are no restrictions, then why not?
There is also another reason for the increase in the number of people using personal loans for business. Apparently, there is a startup boom in the USA, according to the Peterson Institute for International Economics. In 2020, there was a 24% increase in new businesses compared to 2019. If anything, COVID-19 has brought out the enterprising spirit of Americans.
3. Covering Other Notable Expenses
The US economy took a massive hit from the pandemic. Under such conditions, it is not surprising that 64% of Americans worry about high-interest rates on credit cards. Stress levels, therefore, increased. But this also brought about bad spending habits. For example, sales of sporting goods, hobbies, musical instruments, and books increased by 39% since the pandemic began.
With more than 70% of people spending on things they want instead of what is needed, personal debts increased. And then there are the sudden expenses. A medical bill is one, and so are funeral expenses. Another area where people spend is home improvement or repair.
What Pros and Cons Do You Need to Know About Personal Loans?
Before deciding, remember not to only look at how a personal loan benefits you. There are always downsides to consider each time you borrow money. Once you understand the pros and cons, you can avoid the dreaded debt trap, enabling you to make an informed financial decision.
- Flexible and versatile. Many loan types – such as student loans, car loans, mortgages, home equity loans – have specific uses. On the other hand, personal loans are versatile in that you can use them for almost anything. They also have flexible terms which allow you to customize a suitable and manageable repayment schedule.
- Lower APR. The competition between lenders is stiff. It is, of course, in your favor, as evidenced by low APRs. Take debt consolidation as an example. By exchanging those high-interest debts with a personal loan, you end up saving money.
- Higher Borrowing Limits. Most personal loan funds amount up to $50,000.
- No Collateral. Most lenders can offer you an unsecured personal loan. But in exchange for peace of mind, the APR may be a little bit higher than a secured loan.
- Fewer Accounts to Manage. When you use a personal loan to pay off multiple credit card accounts (and other debts), you also reduce tracking various monthly payments.
- Not Always the Lowest APR. While it may be superior to payday loans, it is not always the best choice. For example, a payday loan alternative from a credit union may have lower APRs. Of concern, too, is if you have a terrible history of keeping up with payments. Lenders are going to charge you higher interest for having a lower credit score.
- Higher Fees and Penalties. Similar to APRs, the other costs of obtaining a loan can be considerable. Most significantly, for people with a bad credit score, lenders charge more expensive fees.
- High Monthly Payment. Unlike credit cards, where you can adjust monthly payments, personal loans have fixed monthly installments. It may present some difficulties in certain situations – reduction in income or sudden expenses.
- End Up with More Debt. A personal loan is a debt. Regardless of how you use the money, you have to repay the loan. If your financial situation turns south – losing a job, incurring emergency expenses, and more – you may end up with more debts.
How Does Your Credit Score Affect Interest Rates?
Credit history plays a huge role in the APR of personal loans.
Table 2. Personal Loan Interest Rates by Credit Scores
|28.5% – 32.0%
|17.8% – 19.9%
|13.5% – 15.5%
|10.3% – 12.5%
As you can see, the difference between having an excellent or lousy credit rating ranges from 18.2% to 19.5%. Besides paying higher interests, it is also more challenging to get a personal loan.
Here are some things you can do to improve your credit score if it is low.
- Review Credit Reports. Retrieve your credit reports from Equifax, Experian, and TransUnion – the three major credit bureaus. You can do that through AnnualCreditReport.com (free once a year). Make sure ALL the details – personal information and payment history – are accurate.
- Payments. Payment history accounts for 35% of FICO credit scores (used by 90% of lenders). Strive to pay bills on time. In time, your credit history should improve. You can also consider using autopay to ensure you pay on time.
- Credit Usage. How much and often you use credit cards accounts for 30% of FICO credit scores. Try charging as much of your expenses on credit cards. While at it, remember to keep credit card utilization to 30% of the credit limit. Besides paying on time, aim to lower your credit card debt to 10% to improve your credit score.
When Is the Right Time to Get a Personal Loan?
Being smart about money helps you clear debts sooner rather than later. In principle, there are a few conditions that merit taking out a personal loan.
- Lower interest payments. If your credit card balance is several thousand dollars, take out a personal loan to pay off your existing debts. Not only is a single personal loan easier to manage, but you can also save money because of the lower APR.
- Use the money to earn more money. Loaning money to start or fund a business is a common practice. After careful thought and planning, there is nothing wrong with starting a new business using a loan. If anything, keep the personal loan amount manageable just in case.
- Necessary expenses. Some people thought of taking out a personal loan to fund a travel vacation. Others spend on home improvements (not repairs). These are expenses that you may want to avoid. Instead of going into more debt, is it not better to reduce debts? But there are circumstances in which you need to spend. As long as you deem it not having any other choice, it may be the right time to take out a personal loan.
When Should You Not Take Out a Personal Loan?
A couple of things should come to mind before taking out a personal loan. One is the importance of where that money goes, while another is repaying the debt.
- Lack of financial stability. When you are on the verge of taking a personal loan, think twice. If there is one thing that the pandemic taught us, circumstances beyond your control can change the job climate. So many people lost their jobs and have a difficult time paying off their debts. Some also sank deeper into more debts because they do not have sufficient funds to repay.
- Unnecessary expenses. As a general rule, avoid borrowing money to spend on luxuries. Since you think you can repay the loan, then you might as well put more money into other debts to clear them earlier. Another thing to consider is saving emergency funds to get you through unforeseen difficult times.
Consider, too, your credit score. The lower the score, the higher the interest charges and other fees. Are you willing to spend more on an unnecessary large purchase? If you were to miss even a monthly payment, that would reflect negatively on your credit history.
Are Personal Loans Good or Bad?
A personal loan works both ways. It benefits you most you use the money to:
- Consolidate high-interest debts
- Consolidate credit card debt or student loans
- Make a large purchase of an essential item
In the end, only you can decide why you should get a secured or unsecured personal loan. You can do yourself a favor by sticking to long-term gratification. In other words, make decisions while considering the future. After all, it is better to be debt-free sooner rather than later.
When people ask, “What is a benefit of obtaining a personal loan?” An ideal answer is to ease the financial burden. You can learn practical tips and strategies to save money and grow your bank account at FiLife. Not only that but there is also plenty of information on different lenders and loan options.