Believing personal loan myths could cause you to pay too much for financing. Or mismanage your debt. So here are five facts you must know about personal loans before choosing any type of financing.
Myth#1: Personal loans are only for people with excellent credit
This one is just not true. Yes, if you have a high credit score, you have more personal loan choices. And you qualify for lower interest rates. But there are also personal loan lenders that specialize in lending to people with lower credit scores. You want to shop and compare products from companies that work with consumers with credit ratings like yours. And that goes for all consumers, in every credit score tier.
One thing that personal loan borrowers with low credit scores need to watch out for are pay day and title lenders masquerading as personal loan vendors. You’ll know these fakers by their crazy claims (personal loans with no credit check, for instance). They offer extremely short terms (weeks instead of years). And you’ll pay very high interest rates and fees. (Sometimes these exceed 100% per year.) Avoid these providers because they can trap you into a cycle of debt, refinancing your loan again and again as your balance grows.
Myth #2: Personal loans have high interest rates
The average interest rate for personal loan borrowers, as of this writing, is between 10% and 11%. That would be high if you were talking about a mortgage. Or even an auto loan. But a mortgage or auto loan is secured by a very large asset, which the lender can take and sell if you fail to repay your balance.
Secured loans are safer for lenders, and that’s reflected in the lower interest rate. The financing that more closely resembles a personal loan is the credit card. Credit cards are unsecured, like personal loans, and their rates average 7% higher than personal loans as of this writing.
Myth #3: You can walk away from unsecured loans
One “advantage” of personal loans often touted in articles like this is that personal loans don’t require collateral. “Collateral” is any asset, like a car, boat or home, that the lender can repossess and liquidate if you don’t repay your loan. Personal loans are only backed by your promise to repay.
However, there are consequences to breaking that promise. Lenders can send your account to a collection agency. They can sue you and obtain a judgment. And once they have a judgment, they may be able to garnish your wages, place a lien on your home or empty your bank account. That’s up to your state laws and the judge.
Myth #4: Personal loans are hard to get
Actually, personal loans are much easier to apply for and receive than most kinds of financing. Spend a few hours in an auto dealership with the financing desk and you’ll see how punishing the process can be. But you can apply for personal loans online. The form is usually short. You’ll authorize a credit check and have your money in days or even hours.
Expect to pay higher fees for faster processing. If you have available credit, like credit cards, you may be able to save by using them for immediate needs. Then get a personal loan with the lowest available interest rate. And pay off the card before you incur interest charges.
Myth #5: Personal loans hurt your credit score
Some consumers believe that any debt will cause their FICO score to decrease. That’s probably because a new account drops the average age of your accounts, and inquiries for credit applications do temporarily cause your score to fall by about five points. If you have several maxed-out credit cards and then you add a personal loan for a vacation to the mix, your FICO is likely to head south because you are already carrying a lot of debt and then adding more.
However, if you use a personal loan to pay off those maxed-out credit cards, you can increase your score — and do it fairly quickly. That’s because credit scoring models count installment debt like personal loans differently then they do revolving debt like credit cards. When your credit card balances are high compared to your credit limits, your FICO takes a hit. Carrying balances exceeding 30% of your credit limits usually pulls your score down.
But when you use a personal loan to pay off your credit cards, that percentage, called your “utilization ratio” drops to zero. Refrain from carrying credit card balances once you have shifted that debt to an installment loan, and your finances and credit score will get healthier every month.
And if you have very little information on your credit report, a personal loan can also increase your score. That’s because you can be penalized for using too little credit as well as too much. Paying off a personal loan on time can add good credit history and raise your FICO score.
Personal loan myths: who benefits from borrowing?
If you have a home equity line of credit already in place, it might be a better source of financing than a personal loan. Low-interest loans or grants from government or charitable organizations can be a great money source if you meet their eligibility requirements. And people with serious debt problems may need more help than a personal loan can offer — like debt management or credit counseling.
However, many other consumers find that personal loans are the best way to finance many things. Personal loans usually come with fixed rates that are substantially lower than credit card rates. So if you can get a lower interest rate, and afford a payment that will clear higher-interest debt, a personal loan can help get your finances back on track.
Personal loans beat credit cards for large purchases when their interest rates are lower. And fixed rates and payments make budgeting easier. You can use credit cards to get rewards or a low introductory rate, then pay them off with a personal loan before the higher interest kicks in.
If you don’t need a huge amount of cash, personal loans can be more economical than home equity loans, even if their interest rates are higher. It depends on the home equity loan setup costs, which can be similar to those of a mortgage.