Personal loans work differently than other forms of consumer debt, such as credit cards or auto loans.
Personal loans are usually unsecured funds that a bank, credit union, or other financial institution lends you. The terms are usually between two and seven years, depending on the loan size. Interest rates vary and depend largely on your credit rating.
Taking on additional debt with a personal loan can be beneficial provided you use the money wisely.
The best personal loans can help consumers save money by swapping high-interest credit card debt for loans with lower interest rates and fixed monthly payments.
Learn how personal loans can help you save money and when personal loans might not make sense for your situation.
Personal Loans and Debt Consolidation
Managing multiple payments can be a chore, especially if you accidentally forget to make a payment and are assessed a hefty late payment penalty. Late payments also can adversely affect your credit score.
Debt consolidation is one of the primary reasons people take out personal loans. Here’s a breakdown of how you can make debt consolidation work for you.
What is debt consolidation?
Debt consolidation is the process of taking out a personal loan (or obtaining some other type of financing) to consolidate all or parts of your major debt into a single payment.
Combining four credit card payments into one payment with a personal loan can alleviate or reduce your chances of missing payments, and it also can save a great deal of money in interest payments if you can secure favorable loan terms.
Compare personal loans to find the best loan terms for debt consolidation and more:
How Debt Consolidation Saves Money
If you take out a personal loan, you won’t be alleviating any of the debt you’ve already incurred. However, you can get rid of high-interest credit cards and other forms of “bad” debt for a loan with a better interest rate that could save you thousands in interest payments over the course of the loan.
Look at the example below. Let’s assume you have three credit cards with a total balance of $20,000. The average APR, or interest rate, for your cards is 18%. However, due to your excellent credit history, you can get a personal loan with a 7% interest rate.
Credit Card vs. Personal Loan for Debt Consolidation
The difference is striking. In this example, a personal loan not only pays off your debt almost three years faster but also saves $14,256 in interest. Granted the payment is slightly higher, but the benefits are worth the burden of slightly higher monthly installment payments.
How to Consolidate Debt With a Personal Loan
Obtaining a personal loan is fairly easy, especially if you have good credit.
In some instances, if you have excellent credit and payment histories, your credit card issuer will send you pre-approved offers for a personal loan. Other avenues for personal or credit card consolidation loans include banks, credit unions, and online lenders.
Loan limits and qualifications vary between lenders, but you may be able to borrow as much as $50,000 or more. You can use the funds from your personal loan to pay off your credit cards or other forms of debt directly. Still, some lenders may require you to provide credit card account numbers so they can pay the issuer directly rather than depositing funds directly into your checking account.
If you have a fair to poor credit rating from one of the three major credit reporting agencies, you still may be able to qualify for a personal loan; however, your interest rate likely will be significantly higher than it would be for a more credit-worthy borrower. In this instance, you’ll have to weigh your options carefully, especially if the loan carries an origination fee and you won’t save much in interest payments.
When does debt consolidation work best?
Debt consolidation works best for creditworthy borrowers who can eliminate “bad” debt by taking out a personal loan that has a more favorable interest rate.
A “good” credit rating is a FICO score between 670 and 739, which should help you secure a better interest rate than what you are currently paying on your credit cards.
A debt consolidation loan may not be a good option if you have fair credit — a FICO score between 580 and 669 — because interest rates may be too high to save you any real money.
Taking Out a Personal Loan to Pay for a Large Expense
Figuring out how to pay for unexpected expenses can be stressful, especially if they are big-ticket purchases that exceed your personal savings.
In some instances, it could be beneficial to take out a personal loan to pay for a large expense versus charging it to your credit cards or eating away at your savings.
You can take out a personal loan to pay for a wide range of large expenses that typically cost many thousands of dollars, including:
- Medical expenses
- Home repairs or home improvements
- Weddings
- Funerals
- Moving expenses
- Travel
- Graduations
If you don’t have the funds to pay for these expenses, you likely could save money by taking out a personal loan rather than increasing your credit card debt.
A personal loan with a fixed payment and a 10% interest rate can save you thousands of dollars in interest payments versus credit card debt at 18 to 20%. You’ll also be able to shed the payments sooner with a fixed monthly payment and set loan maturation date.
When does a personal loan for a large expense work best?
It’s important to carefully consider whether you can truly afford the financial burden of additional debt before taking out a personal loan.
There could be other avenues of financing available, such as a home equity line of credit for home improvements, that might be a better option. However, if that’s not an option, carefully researching personal loan lenders to find the best loan terms could be a viable option to pay for large expenses.
Taking Out a Personal Loan to Improve Your Credit Score
Taking out a personal loan can actually improve your credit score.
Credit reporting agencies examine five different factors when determining your credit score:
- Payment history
- Current debt
- Credit history
- Types of credit
- New credit inquiries
These factors aren’t weighted equally.
Payment history can account for as much as 35% of your overall credit score. Current debts and credit utilization account for 30%, and creditors recommend keeping your total credit usage to under 30% of your available credit in order to generate a favorable FICO score in this category.
Using a personal loan to pay off credit card debt can decrease your credit usage, resulting in a more favorable percentage of debt to available credit. You aren’t increasing your total debt load, either; instead, you are swapping one form of debt for another.
You’ll also be adding a different type of credit, which can actually give a slight boost to credit since credit reporting agencies prefer to see consumers using several different types of credit, such as revolving accounts and installment loans.
As previously noted, personal loans with favorable interest rates compared to credit card debt also can save you a great deal of money in interest.
When does a personal loan work best to improve your credit score?
Personal loans can be an excellent way to reduce your credit card debt and overall credit usage.
Although you’ll still have the same amount of debt, it likely will be at a lower interest rate. You also can use the funds to catch up on any late or missed payments that will drastically affect the strength of your credit score.
When a Personal Loan May Not Be Your Best Bet
There are many scenarios when a personal loan may not be your best option. Here are five:
- You can get a balance transfer card with 0% interest. Balance transfers with low introductory rates might make more sense than a loan with a higher interest rate.
- You don’t have good credit. There are personal loans available to borrowers with bad or fair credit, but these borrowers usually won’t receive favorable loan terms.
- You are living above your means. Racking up credit card debt is never a good idea. You may have to reconsider your spending habits.
- Taking on additional debt. Don’t take out a personal loan for something that’s not absolutely necessary. Carefully consider whether you truly need the burden of assuming more debt.
- You have inconsistent income. Loan payments are like full moons — they come about each month. You’ll be accountable for your personal loan payments regardless of the stability of your income stream.
Don’t make a snap judgment just because you qualify for a personal loan. Analyze your financial situation carefully before proceeding.
Frequently Asked Questions (FAQs)
Here are three commonly asked questions about personal loans:
Can I get a personal loan if I am unemployed?
Possibly, but if you are struggling financially and might have trouble making loan payments, it might not be your best course of action.
How much can I borrow?
Loan limits vary by lender. Some banks may let you borrow between $3,000 and $100,000 provided you meet lending requirements. The majority of personal loan lenders offer loans between $5,000 and $50,000, however.
What can I use the funds for?
Refinancing high-interest debt for a more favorable loan is one of the most common ways people use personal loans. You can use the funds to cover just about anything you want, though. The key is being responsible with the money.
There are many different factors to consider before taking out a personal loan. Never take out a personal loan unless you are sure you can pay it back since you could significantly damage your credit score if you can’t. If you want to eliminate high-interest debt, however, a personal loan could be an excellent option.
