They are the fastest growing type of loan – and they could help save you money and improve your credit score.
Here’s what you need to know about personal loans and how they can benefit you.
What Is A Personal Loan?
A personal loan is an unsecured loan typically from $1,000 – $100,000 typically with a fixed interest rate that can be used to consolidate debt or make a large purchase. The term “unsecured” means you don’t have to put up any collateral.
Depending on your credit profile, you may be able to qualify for a low-interest rate personal loan and save money compared to a credit card. Interest rates on personal loans are often much lower than the interest rates on credit cards, which typically range from 10-20% (or higher).
The interest rate on your personal loan will depend on several factors, which may include your credit score, credit history, monthly cash flow and debt-to-income ratio.
The stronger your credit profile and history of financial responsibility, the lower the interest rate you can expect.
When Should You Use A Personal Loan?
Personal loans are best for purchases that you plan to repay in less than five years.
Unlike student loans or mortgages that are spent on specific purchases such as education or a home, respectively, personal loans can be spent at your discretion.
Therefore, you have more flexibility and personal choice when using a personal loan.
1. Debt Consolidation and Credit Card Debt Consolidation
Debt consolidation is one of the most popular – and smartest – reasons to obtain a personal loan.
You can use a personal loan for debt consolidation in two primary ways:
- Pay off existing high-interest debt (such as credit card debt) with a lower-interest personal loan
- Combine different types of existing debt into a single personal loan to make debt repayment more organized and manageable
You can use a personal loan to consolidate high-interest credit card debt, and obtain a lower interest rate to help pay off your debt faster.
Of course, that assumes you will take advantage of the lower interest rate and lower monthly payments to accelerate your credit card pay off.
- DO use a personal loan to repay credit card debt and become debt-free.
- DO NOT use a personal loan as a tool to postpone debt repayment.
How A Personal Loan Can Cut Your Credit Card Interest By 50%
Here’s how to cut your credit card interest rate by up to 50%:
- Compare the interest rate on your credit card with the interest rate on the personal loan to determine which interest rate is lower.
- If you have good or excellent credit, you should be able to obtain an interest rate lower than your current credit card interest rate.
- If you qualify for a lower interest rate, make sure you can repay the personal loan over the loan period (such as five years, for example). Having a shorter-term loan repayment period can not only save you interest costs, but also instill discipline to retire your debt more quickly.
You can use this credit card consolidation calculator to see how much money you can save with a credit card consolidation loan.
Are There Alternatives To A Personal Loan?
There are several alternatives to a personal loan. For example, if you have good or excellent credit and plan to pay-off your existing credit card debt in 12-15 months, you could get a 0% APR credit card and make a balance transfer.
If you own your home, a home equity loan is usually a lower cost option. However, unlike a personal loan, a home equity loan is a secured loan so that means your home serves as collateral and can be claimed by the lender if you do not repay the debt.
How A Personal Loan Can Improve Your Credit Score
Can borrowing debt actually improve your credit score?
Surprisingly, yes. Here’s how.
Lenders evaluate your credit card utilization, or the relationship between your credit limit and spending in a given month. If you have credit card debt and your credit utilization is too high, lenders may consider you higher risk.
Here are some ways to manage your credit card utilization:
- set up automatic balance alerts
- ask your lender to raise your credit limit (this may involve a hard credit pull so check with your lender first)
- rather than pay your balance with a single payment at the end of the month, make multiple payments throughout the month
You can also use a personal loan to help with credit utilization. For example, you may improve your credit score if you replace credit card debt with a personal loan.
Why? A personal loan is an installment loan, which means a personal loan carries a fixed repayment term. Credit cards, however, are revolving loans and have no fixed repayment term. Therefore, when you swap credit card debt for a personal loan, you can lower your credit utilization and also diversify your debt types.
2. Medical Expenses
If you have a medical emergency or unexpected medical expense and are unable to pay the full cost in cash upfront, a personal loan can be a better solution than a credit card.
Often, you can qualify for a higher loan amount with a personal loan than a credit card, which may be necessary for your health expenses.
3. Emergency Home Repair Or Home Improvement
If you need to complete an emergency home repair or a small home improvement project, and cannot take a home equity loan, access a line of credit or refinance your mortgage, then a personal loan may be an attractive option.
A personal loan can make good financial sense for a home renovation project if the renovation improves the financial value of your home (and the cost to borrow the personal loan is less than the expected appreciation of your home as a result of the renovation project).
4. Other Uses For A Personal Loan
A personal loan can used to help pay for other key life events, including an engagement ring, wedding, moving, honeymoon and many other uses.
Like any debt obligation, ask yourself whether your reason to obtain a personal loan is a “want” or a “need.”
Final Thoughts: Personal Loans
Given the increase in online lending, the good news is that you can apply and receive cash from a personal loan within days.
A personal loan, however, should not be an excuse to acquire more debt. Rather, a personal loan can be a helpful tool for a smart borrower who has an action plan to get debt-free and march down the path toward financial freedom.
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