Borrowing money can feel like a practical solution to immediate financial needs, whether it’s consolidating debt, funding a large purchase, or covering emergency expenses.
Among the various borrowing options available, personal loans are one of the most popular. However, it’s important to carefully assess whether taking out a personal loan is the right financial decision for you.
Let’s dive into the key factors you should consider: interest rates, the unsecured nature of the loan, the amount you can borrow, and the impact on your credit score.
1. High Interest Rates & Unsecured Debts
A personal loan generally has a higher interest rate compared to other borrowing options. This is often the case because personal loans are unsecured debts, meaning there is no posted collateral that the lender can seize in the event of a default.
For example, assume you want to borrow money to purchase a new car. The car costs $40,000, and you plan to give the dealer $5,000 and borrow the remaining $35,000. The car serves as collateral for the debt. The loan is considered a “secured” loan because of the collateral. For this reason, the Annual Percentage Rate (APR) on the loan is relatively low. If you default on the payments, the bank can repossess the car and sell it to try and cover its losses.
In contrast, assume you want to borrow a personal loan of $10,000 from a credit card company. No collateral is posted, so the debt is an “unsecured” note obligation. Because the debt is unsecured, the credit card company wants to charge a very high interest rate, given the greater risks.
Personal loan interest rates can range from 10% to 35%. For example, if you borrow $10,000 with an interest rate of 20%, you could end up paying over $5,800 in interest over a 5-year loan. So, evaluating whether the loan’s cost is worth the convenience of having cash on hand is critical.
2. How Much Money Can You Access?
The amount of money you can borrow using a personal loan will largely depend on your current income, credit score, credit utilization ratio, and debt-to-income ratio.
Lenders generally offer loan amounts ranging from $1,000 to $40,000, although some individuals with excellent credit and higher income may be able to access substantially more funds.
Before taking out a loan, think carefully about the amount you actually need. Borrowing more than necessary increases your monthly payment and the total interest expense you’ll pay over the life of the loan. Conversely, borrowing less than you need could lead you to scramble to acquire additional funds from a different lender.
3. Impact on Your Credit Score
Taking out a personal loan will certainly impact your credit score. The impact may be positive or negative, depending on how much you borrow, your diligence in making timely payments, and how much existing debts you have.
According to Experian, your credit score is impacted by the following factors and relevant percentages.
- Payment History: 35%
- Amount of Debt Owed: 30%
- Length of Credit History: 15%
- Credit Mix: 10%
- New Credit Inquiries: 10%
Notice how your payment history and amount of debt owed are the greatest weighted factors impacing your credit score.
A personal loan can improve your credit score by adding diversity to your credit profile. Lenders prefer to see a variety of credit types, such as personal loans, credit cards, auto loans, home mortgages, and lines of credit.
When you apply for a personal loan, the lender will perform a hard credit inquiry, which can temporarily lower your credit score by a few points. This is standard practice and generally happens whenever you apply for new credit, whether it is a personal loan, credit card, or mortgage application.
Making regular, on-time payments will positively impact your payment history, which accounts for 35% of your FICO score. It is highly recommended that when you borrow funds using a personal loan you setup automatic payments via direct debit from your bank account. This ensures that each month the full payment is made on a timely basis. If you’re unable to keep up with monthly payments, your credit score will be negatively impacted.
Conclusion
A personal loan can be a great tool for those who need quick cash or want to consolidate their debts; however, you should seriously consider its benefits and drawbacks. It’s essential to weigh the high interest rates, lack of collateral, borrowing limits, and potential impact on your credit score before applying for a personal loan.
If you’re using the loan to consolidate high-interest debt or fund emergency expenses, it may be a good move. Always shop around, compare offers, and consider speaking with a financial advisor to determine whether a personal loan is the best choice for your unique situation.