A personal loans loan is a great option for many people looking to consolidate credit card debt or make a large, one-time purchase. However, depending on a person’s financial profile, it could also result in years of crushing payments or defaulting on the loan altogether.
A personal loan uses installments. A bank, credit union, or online lender issues the loan at a fixed rate and amortization period. The time frame can range anywhere from a couple of years up to seven or eight.
Like most other loans, personal loans depend on the financial health of the borrower. Those with high credit scores will get a better interest rate than those with a low credit score. Similarly, those with better credit will have access to higher loan amounts.
There are many different types of personal loans. Some are secured and use an asset of the borrower as collateral against the personal loan. These typically have lower interest rates as they pose less of a risk to the lender. Unsecured loans have higher rates as the lender assumes greater risk since there is no collateral from the borrower.
Below is a list of reasons for when a personal loan might not be a good option for a borrower.
1. Personal Loans for Quick Debt Relief
Possibly one of the worst ways to use a personal loan is for temporary relief of monthly debt.
If a borrower experiences regular shortages each month, then they might see a personal loan as a bridge to make ends meet, in the short term. Personal loans online are very convenient, but potential borrowers should beware.
A personal loan means monthly installments. Once a borrower uses that loan to temporarily halt debt, the payments for the loan don’t go away. Eventually, the borrower is adding another monthly payment and has made their situation that much worse.
2. Using Personal Loans with No Credit Check
Unless necessary, these types of loans are not a good option. There are several different types, and some are more dangerous than others.
Payday loans rely on the borrower’s employment. The lender will give the borrower an advance on their paycheck. In return, the borrower gives the lender access to their bank account. The next payday, the lender will go in and take the amount back – plus interest, which is extremely high.
They offer very high-interest rates and are based on the borrower’s employment. These loans offer fixed rates and amortization periods, but the rates are so high they should only be used when there are no other options.
Borrowers offer collateral such as a car title or other item of value. The lender then offers a lower rate of interest and higher loan amount than other no credit check loan options. If the borrower fails or is it late in their payments, the lender can take the collateral.
3. Using Personal Loans for Luxury Purchases
Using a personal loan to buy a diamond encrusted dog collar is not a good idea. Even using a personal loan to fund a family vacation isn’t recommended.
Taking out a loan that will saddle the borrower with monthly payments for many years should only be reserved for essential items. An extra hundred dollars a month might not seem like much. However, what if there is an emergency and another personal loan is required?
Then the borrower has several monthly payments to pay off personal loans.
The debt spiral can get out of control quickly unless borrowers limit their loans to essentials only.
4. Paying Off Small Debts with Personal Loans
Let’s say a person has a debt of around ten thousand dollars spread across several credit cards. They are in a position to pay off that debt over the next year and a half, but the interest rates on those credit cards are high. Thus, paying off those cards is more difficult.
Why not use a personal loan to consolidate the high-interest debts into a more manageable, lower interest monthly payment? First, anyone carrying debt across multiple credit cards is at risk or likely has a lower credit score. As a result, the rate the borrower could get on a personal loan likely would not be much better than what they have on their credit card.
Second, there are credit cards that offer zero interest for balance transfers up to 20 months, or more. Using this type of credit card makes more sense instead of taking out a cash loan.
5. Using a Personal Loan to Invest
A personal loan is a great vehicle for fast cash, or to make a large payment on a purchase that somehow adds value to a home or business. On the other hand, personal loans are not good for investments of any kind.
Regardless of the borrower’s expertise in all matters of investing, risk, and personal loan do not mix well. The most solid investments are often long term. Personal loans do not often have amortization periods over eight years. Therefore, using these types of loans for investments might result in an inability to make payments years down the road if the investment is not yet making money.
6. Homeowners Doing Renovations
Typically taking out a personal loan to refurbish a home isn’t a bad idea. However, for those who actually own their home or most of it, a personal loan is not the best way to renovate.
A better option for owners with equity in their house is to tap a home equity line of credit – a HELOC – which will almost always have a lower interest rate than a personal loan. As well, an equity line of credit allows borrowers to access what they need. Thus, they are more flexible than personal loans making them ideal for home renovations.
7. Personal Loans for Education
Using personal loans for education might seem like a good idea, particularly for young people with no credit, struggling to pay tuition. However, those young people are exactly the type of people who would get saddled with a high-interest personal loan.
Instead, financing education through the myriad options offered by government-backed student loan lenders is a better option. These lenders offer far lower interest rates to students and parents than regular personal loans.