When Is a Personal Loan a Bad Idea?
Personal loans are simple financial products designed to meet a variety of needs. Sometimes, however, another solution might be better for you. Understanding when a personal loan is a bad idea can help you choose the right product for your situation.
Advantages and Disadvantages of Personal Loans
Personal loans have their advantages and drawbacks.
The biggest drawback for personal loans is that their interest rates are usually higher than those of mortgages and auto loans. That said, there are personal loans for highly qualified applicants with rates that approach those of home equity financing.
When Is a Personal Loan a Bad Idea?
There are times when you should not borrow with a personal loan. Here are several scenarios in which a personal loan might not be the best option.
You’re an overspender
Personal loans can be excellent tools for consolidating credit cards and other debt. Replacing credit card balances with a personal loan can save you interest charges, help you get out of debt faster, and improve your credit score.
But if you amassed debt by spending more than you earn, you may have an underlying problem that can’t be solved by a personal loan. If you consolidate your credit cards and then run them back up, you’ll be in worse shape than before. Learn to budget and control your spending before borrowing more.
Alternative to personal loans: credit counseling, debt management plan
You have a short-term need
Personal loans for travel or to pay for an event have their place. You might be able to travel for half price if you book and pay a year out. Take a one-year loan and enjoy your savings. Similarly, you may have to pay your wedding venue and catering deposits a year or more upfront whether you have cash or not. In that case, financing with a short-term loan can solve your problem.
But personal finance experts do not recommend financing short-term needs with long-term loans. You don’t want to spend the next five or 10 years paying for your wedding or vacation.
Alternative to long-term personal loans: shorten your repayment term or borrow less
Secured financing is cheaper
If you’re buying a car, check financing offers before looking at unsecured personal loans. Auto loans often come with lower interest rates than personal loans. That said, you should compare rates before making a decision because sometimes personal loans are cheaper and don’t require you to make a down payment.
Another source of cheap secured financing is a home equity loan or line of credit. If you have home equity, you can often get a lower interest rate and payment than available from a personal loan provider. Finally, not all personal loans are unsecured — you may be able to get a great deal with a secured personal loan.
Alternative to unsecured personal loans: auto loans, home equity loans, secured personal loans
You have student loan protections
Refinancing student loans with personal loans can save you money if you qualify for a lower interest rate. Unlike federally backed student loans, personal loans can be discharged in bankruptcy if you’re in financial trouble.
But you lose valuable protections, like deferment, forbearance, forgiveness programs, grace periods, and income-driven repayment plans. Finally, many personal loan providers prohibit using loan proceeds to repay student loans, so you may have problems qualifying for financing.
Alternative to personal loans: lower your payment with an income-driven repayment plan
Your business is risky
Personal loans are popular with entrepreneurs and investors because there is almost no required paperwork. You don’t have to submit a business plan and your money comes quickly. However, businesses and investments fail all the time, and in some industries, losers far outnumber winners.
If you borrow to fund a business or investment, determine how you’ll repay the loan if you’re out of business or your investment becomes worthless. If you can’t afford to lose, you probably can’t afford to borrow.
Alternative to personal loans: secured business loans, personal savings, sell assets
FAQs
What are good alternatives to personal loans?
The cheapest alternatives to unsecured personal loans are home equity financing, auto loans, and balance transfer credit cards. Other options include selling unused assets or picking up side hustles for extra money. For smaller amounts or just for convenience, credit cards can be the best choice.
What are personal loan interest rates?
Personal loan interest rates from mainstream lenders start under 5% and go as high as 36%. The rate you’re offered depends on your credit rating, income and debts, loan amount, loan term, use, and if you authorize automatic payments.
Can you get a personal loan with bad credit?
Consumers with great credit have access to many more products than those with poor credit scores. However, there are lenders that work with borrowers who have poor credit. Expect to pay interest rates of up to 36%. Note that any lender advertising personal loans with no credit check is actually offering a check advance or auto title loan with extremely high fees. Avoid those products, which can trap you into a long cycle of debt and financial insecurity.
Can personal loans be refinanced?
Most personal loans do not have prepayment penalties and can be paid off at any time. You might choose to use one personal loan to repay another if your credit score has improved and you’re eligible for a better rate. Or you might want to extend your repayment term and lower your monthly payment.
What are good uses for personal loans?
You can use a personal loan for almost anything. Here are some popular purposes:
- Debt consolidation can lower your interest rate, accelerate your repayment, and improve your credit score almost instantly.
- Make large purchases like tiny houses, RVs, or home improvements with no down payment requirement.
- Provide backup cash flow for a small business.
- Take advantage of deep discounts on travel by booking and paying in advance.
- Pay for medical costs (most providers want payment upfront for non-emergency procedures, even if waiting worsens your condition or you’re in pain).
Personal loans are individual, and a use that’s good for one person could be bad for another. If you’re in doubt, consult an accountant or credit counselor before borrowing.
