The Do’s and Don’ts of Personal Loans

Personal loans can be taken for a variety of reasons, some good and some bad. Regardless of your motivation, if you take out a personal loan you can’t pay back, you could face some dire financial consequences, ranging from a ruined credit history to bankruptcy. That’s why potential borrowers should first consider whether they are responsible and financially secure enough to repay a personal loan.

A potential borrower’s second consideration should be whether or not a personal loan would be the best or most responsible way to cover the expense they are dealing with. While there are some instances in which a loan makes perfect sense, there are plenty of others in which borrowing money simply isn’t worth the risk. Below, we’ll explore these do’s and don’ts of personal loans.

What is a personal loan?

As the name implies, a personal loan is a type of credit that consumers can take out for any number of personal reasons.

Personal loans are installment loans, and approved applicants receive a lump sum of cash that must be repaid in fixed amounts on a monthly basis over the course of the loan term. Lenders look at an applicant’s credit and income to determine whether they are capable of repaying a loan. Applicants with higher credit scores are more likely to be approved, and to qualify for lower rates.

Good reasons to take out a personal loan

Just because you qualify for a personal loan, doesn’t mean you should take one out. There are many justifiable reasons to borrow money, including these common uses of a personal loan:

Consolidating high-interest debt

Taking on debt to pay off debt may seem like robbing Peter to pay Paul, but if you’re able to get a personal loan that has a lower interest rate than your current debt, it’s actually a very smart financial move.

In 2019, the average credit card interest rate is 19.24% for new offers, and 14.14% for existing accounts, according to WalletHub’s Credit Card Landscape Report. By contrast, personal loans come with interest rates that are sometimes as low as 5%, according to Value Penguin. Furthermore, personal loans carry fixed interest rates, unlike credit cards with more volatile variable interest rates.

If you have a significant amount of high-interest debt it may make sense to consolidate it and take out a personal loan to pay it all off. You will then be able to pay off the personal loan in fixed monthly payments over a set number of years, and never have to worry about the interest rate rising and increasing your debt burden.

Home repairs or remodels

Home improvement is another popular reason for taking out a personal loan. If you have pricey home repairs not covered by homeowners insurance, or would like to do some substantial renovations or remodeling, a personal loan can help you cover the high costs of fixes and upgrades.

A personal loan is particularly prudent if you plan to sell the home in the future, in which case the repair and remodeling represents an investment in the property that will hopefully pay off when it’s time to put the house on the market.

Entrepreneurship

Most aspiring entrepreneurs don’t have all of the capital they need to get their business off the ground. A personal loan can help cover your startup costs, and then as your business grows and starts to turn a profit, you should have the money needed to repay your loan.

Bad reasons to take out a personal loan

There are several good reasons to obtain a personal loan, and many bad reasons. Basically, any sort of discretionary spending on nonessential items is not worth the risk, and you’re better off saving your pennies or, if truly necessary, putting your purchase on a 0% interest credit card.

Here are some expenses you should never cover with a personal loan:

Vacations

No matter how much you may feel you need it, if you have to borrow money to pay for a vacation, you can’t afford to take it. For many, that’s a bitter pill to swallow, but taking out a personal loan to cover your dream trip to Paris or the Bahamas is irresponsible. Even if you are able to eventually repay the loan, you will likely spend years stressing over your payments. You’ll then realize that the few days of rest and relaxation you got to spend lounging on the beach simply weren’t worth the trade-off.

College tuition

Enrolling in any sort of university or college is always a smart way to invest in your future, but paying for it with a personal loan is not so bright. If you need financial aid, you are better off using federal student loans, which come with affordable interest rates, as well as government benefits and protections like deferment, forbearance and income-driven repayment plans.

Investing

Investments are all basically a gamble, and you shouldn’t be using personal loans to cover any uncertain wagers. A hot stock tip can prove as disastrous as a bad horse recommendation at the track, and while you may think you can earn more money investing than you pay in interest on your personal loan, there is no such thing as a “sure thing.” If you invest big and lose big, you’ll lose the price of the personal loan plus interest.

As long as you use them for the right reasons and are capable of making the required monthly payments, personal loans can be a great tool for consolidating old debts or investing in a brighter future.