11 Essential Things to Consider Before Taking Out a Personal Loan

Personal loan calcuation

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Taking out a personal loan can be a lifesaver for many. With that being said, it does have both pros and cons. Your unique financial situation will ultimately determine whether this is the right move for you. In this article, we offer 11 critical points to think through before you make your decision.

Here are 11 things to think about before you take out a personal loan

1. Why are you taking out a personal loan?

Are you short on cash? Eager to make a large purchase? In an emergency situation? Personal loans are good solutions for sound financial investments such as:

  • paying for college or other educational expenses
  • paying for an event like a wedding or funeral
  • consolidating your debt
  • paying off your credit card

It is not, however, in your best financial interest to take out a personal loan for an impulse buy — or without fully understanding your options. You need to take the long view on how this loan amount will fit into your personal budget. The additional tips below will help you develop a clearer picture of a personal loan.

2. Personal loans may have higher interest rates

When it comes to interest rates, a typical 30-year mortgage loan might come to mind. The interest rate on that has hovered around 4% for several years. If you're taking out a personal loan, expect at least double that rate. According to ValuePenguin, the average rate for a personal loan starts at 10% — and goes as high as 28%.

When you refinance your home or take out a home equity line of credit, your property acts as collateral. Therefore, the bank's risk is lower. In contrast, a personal loan is unsecured and has no physical asset to back it up. Because of this, it is a higher risk for the bank, which is one main reason for the higher interest rate.

3. Personal loans can help in a pinch

Personal budget check

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If you find yourself in need of cash due to unexpected bills like a medical emergency or a leaky roof, you may consider using your credit card or taking out a loan on your home. However, using a credit card can be an expensive solution. In addition, you might not have time to look into a home equity loan. This is where a personal loan can come in handy. The funds are usually accessible within two weeks of applying. Although it's not immediate, it might make more financial sense long-term.

4. Your credit score is essential

Because taking out a personal loan does not involve collateral, your credit score is essential in determining your interest rate. If you do not have good credit, you can expect the lender to hike your interest rate. This helps them cover your risk of default. Check out these ways to increase your credit score, so you're in good financial condition before you need to take out a personal loan.

Remember: you can obtain your free credit report and dig into your credit history on your own — or ask for support from a credit repair company.

5. Personal loans are available from different sources

There are more options than your bank when it comes to securing a personal loan. Credit unions often have lower interest rates and origination fees for their personal loans. There are also some new players in the marketplace like Marcus and SoFi that offer easy and quick loan approval along with great rates to those with good credit. These types of loans are new to the industry but still worth checking out.

6. Personal loans can help you save on existing debt

In an effort to consolidate debt — including student loans, credit card debt, mortgages, and auto loans — many people rely on personal loans. This helps them obtain a lower interest rate. Some pioneering lenders will also make monthly payments to your creditors directly with your borrowed funds. This can cut down on the cost and volume of bills you pay each month.

7. Understand the benefits you may be giving up

When it comes to refinancing a student loan, many people roll that debt into a personal loan. But before signing off on the personal loan, read the fine print. In certain cases, you could be losing certain federal benefits like service member benefits or income-based repayment for federal loans. Stay up-to-date with FAFSA or your specific lender to understand the risks of switching over.

8. A different type of financing may be more appropriate

Financial analysis

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Before you take out a personal loan, do some comparison shopping. You may qualify for one of the 0% balance transfer credit cards. These extend up to 21 months with no interest and might be a better fit than a personal loan.

Another solution may be to withdraw money from your retirement savings for a short period, specifically if you have a Roth IRA. Using your retirement account to pay down high-interest debt can be a smart move. According to Charles Schwab, if you withdraw from a Roth IRA before you reach age 59½ and/or if the account is less than five-years-old, you may be subject to certain taxes and penalties.

To avoid penalties, use the withdrawal towards:

  • a first-time home purchase
  • qualified education expenses
  • disability expenses
  • medical expenses or health insurance if you’re unemployed

See full details on the Charles Schwab website.

You also want to make certain you pay back the money in a timely fashion to keep your retirement cushion intact.

9. Know your lender's fee structure

Certain lenders will attempt to add on an insurance policy or other additional expenses when it comes time to close the loan. An insurance policy may or may not be something you want for your loved ones should something unfortunate occur. Do your research and never go with a company that tells you it is a requirement of your loan. Also check to see what type of method they use to calculate the interest (i.e., pre-compute) and if there are any penalties for prepayment. Both of these scenarios will be unfavorable if you pay back the loan ahead of time.

10. Do not use a personal loan to pay for certain expenses

Personal loans can be nice since the lender does not necessarily require you to disclose the reason you are taking out the loan. With that being said, there are certain things you should not take a personal loan out to pay for. These probably will seem obvious, but vacations, your partner's engagement ring, a new wardrobe, gambling, and other luxury purchases should be out of the question. These items should be prioritized only after all of your basic financial needs are met.

11. Taking out a personal loan is a short-term solution

The typical length of a personal loan is below seven years. On the one hand, this is good since borrowing money over long periods can be risky. On the other hand, if you plan on borrowing a large sum of money, regular payments for a personal loan may be too hefty.

Bonus: personal finance tips

Taking out a personal loan goes hand in hand with sound overall financial health. Here are some basic tips to help keep your finances intact on a regular basis.

  • Set aside a portion of your paycheck every month for emergency savings.
  • If you're paying down multiple debts, make sure you're paying down the ones with the highest interest rates first.
  • Use cash back apps and sites like BerryCart to minimize basic expenses — and try to buy items like food and household goods in bulk.
  • Consider spreading out larger retail payments with a tool like Bread.
  • Have a night in with friends and create handmade gifts to keep spending to a minimum.
  • Consider negotiating more favorable rates if your credit score improves or if interest rates shift.
  • Create and stick to a personal budget to minimize expenses.
  • Educate yourself on financial topics you might be fuzzy on like interest rates, mortgages, and retirement savings.

Consider a personal loan in the context of your overall finances

Remember, a personal loan is one tool out of many you can leverage to achieve your long term goals in a secure and steady manner. Check out Credit Marvel's additional guides for repairing your credit, improving your credit score, financial basics, and more to help you get where you want to go.

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