Personal loans offer a straightforward way to borrow money for all kinds of reasons. While they have many advantages over other types of debt, they also have some downsides compared to alternatives. Before you borrow, it’s important to understand the pros and cons of personal loans so you can make an informed decision.
What Are Personal Loans?
Personal loans are installment loans from banks, credit unions, and online lenders that you repay in fixed monthly payments over 2-5 years. Most feature fixed interest rates that never change, providing predictable payment schedules.
Loan amounts typically range from $1,000 to $50,000, though some lenders offer up to $100,000. Personal loans come in two types:
- Unsecured loans: No collateral required—you qualify based on creditworthiness alone.
- Secured loans: Require collateral like a car or savings account, making them easier to qualify for, but putting your assets at risk.
You can use personal loans for nearly any purpose not specifically restricted by the lender, including debt consolidation, home improvements, medical expenses, or major purchases.
"A personal loan … allows individuals to borrow a set amount of money, which they repay in fixed installments over a predetermined period. Personal loans are often used for consolidating debt, making large purchases, or covering medical expenses. In my experience, many of my clients have used them to renovate their homes or pay for major life events like weddings or education costs," says Oliver Morrisey, founder of Empower Wills and Estate Lawyers.
Pros of Personal Loans
Personal loans have many key advantages compared to other types of debt:
Flexible Uses
Personal loans provide exceptional versatility in how you use the funds. You can consolidate debt by paying off multiple loans or credit cards, finance home improvements, purchase appliances, or cover major life expenses like weddings or having a baby.
Essentially, you can use your loan for any legal purpose not specifically banned by your lender (common restrictions include gambling, tuition, or home down payments).
Fixed Interest Rates and Monthly Payments
Personal loans feature fixed interest rates and monthly payments that never change throughout the loan term. This immunity from rate increases provides predictable budgeting and protection against market fluctuations that could make your loan more expensive over time.
Lower Interest Rates
Borrowers with good credit often qualify for personal loan rates lower than credit cards, though rates can vary widely. When you secure a competitive rate, choosing a personal loan over credit cards can generate significant savings.
"Interest rates for personal loans can range from 6% to 36%, depending on factors like credit score, loan term, and income level. A higher credit score typically leads to a lower interest rate," says Morrisey.
Quick Funding
The personal loan process moves rapidly, with many lenders offering online applications, instant decisions, and funding within days or even hours. The timeline depends on the lender's processes, your document preparation, and the chosen funding method.
Flexible Repayment Terms
Most lenders offer loan terms between two and five years, with some extending up to seven years for lower monthly payments. You can typically make extra payments to pay off the loan early, though some lenders charge prepayment penalties.
Credit Score Improvement
Making timely monthly payments on a personal loan builds positive payment history and can boost your credit score over time, making it a valuable credit-building tool.
Cons of Personal Loans
Personal loans also present some disadvantages compared to other debt options:
Higher Interest Rates
Personal loan rates can exceed those of secured debt options like home equity loans, HELOCs, or 401(k) loans. Higher rates increase your total borrowing costs over the loan's lifetime.
Fees
Personal loans may include various fees that increase borrowing costs:
- Loan origination fees: Administrative charges (typically 1-8% of the loan amount) are often deducted from the loan proceeds while requiring repayment of the full borrowed amount.
- Late fees: Penalties for missed payment due dates or grace periods.
- Prepayment penalties: Some lenders charge fees for early payoff, though these are becoming less common.
Borrower Requirements
Lenders impose minimum credit scores, income, and debt-to-income ratio requirements. Failing to meet these standards can result in loan rejection or higher interest rates to compensate for increased risk.
Extra Debt Load
Personal loans add monthly payment obligations to your budget, reducing funds available for other financial priorities. The additional debt increases your debt-to-income ratio, potentially hindering qualification for future loans like mortgages or auto loans.
Missed Payments Negatively Impact Credit
Late payments can severely damage your credit score once they reach 30 days past due and get reported to credit bureaus. Continued delinquency can lead to collections, lawsuits, and long-lasting credit damage. Only borrow if you're confident in your ability to make consistent, timely payments.
Alternatives to Personal Loans
These alternatives can get you access to funds just as easily (or even easier) than personal loans:
Credit Cards
If you can make your monthly payments on time and use your card responsibly, credit cards provide a strong alternative to personal loans. They are easy to set up, accepted almost everywhere, and can be used to buy many of the same things that a personal loan can.
If you want to consolidate credit card debt and you have a great, strong score, you could even qualify for a balance transfer credit card with a 0% intro APR (for a limited time), giving you a way to pay down your debts interest-free.
Home Equity Loan or Home Equity Line of Credit
If you’re a homeowner and you have a significant amount of equity in your home, you could borrow against that equity with one of the following options:
Home equity loans: Installment loans that provide a single lump sum payment to you, which you then pay back over time with a fixed interest rate and fixed monthly payment.
A home equity line of credit (HELOC): Provides you with a line of credit that you can borrow against, up to the limit, similar to a credit card. HELOCs have variable interest rates and fluctuating monthly payments.
Pro tip: Just remember, you are using your home equity to secure your loan. If you fail to make your payments, you risk losing your home.
401(k) Loan
If your employer's 401(k) plan allows it, you can borrow against your retirement savings without a credit check. You're essentially lending money to yourself and paying it back with interest directly into your own account.
- Key advantages: No credit requirements, competitive interest rates, and you pay interest to yourself rather than a lender.
- Major drawbacks: Borrowed funds miss out on potential investment growth, and you typically need to repay the entire balance immediately if you leave your job or face it being treated as a taxable withdrawal with potential penalties.
How to Choose the Right Personal Loan
Personal loan options include traditional banks, credit unions, and online lenders, each with distinct advantages. Banks and credit unions typically offer personalized service, while online lenders provide faster processing, with decisions often within minutes.
Compare Multiple Lenders
Use pre-qualification tools to compare offers from several lenders without affecting your credit score. Many lenders and comparison sites offer instant pre-qualification that shows potential rates and terms.
Key Factors to Evaluate When Choosing a Personal Loan
- Annual percentage rate (APR): Lower APRs reduce total borrowing costs, but consider other factors beyond the rate alone.
- Repayment terms: Choose a timeline that fits your budget—typically 2-7 years, depending on the lender.
- Fees: Compare origination fees, late payment charges, and prepayment penalties that add to total costs.
- Loan amounts: Ensure the lender offers your needed borrowing amount.
- Monthly payments: Verify payments fit comfortably in your budget before committing.
- Lender reputation: Research online reviews and check for regulatory issues or consumer complaints.
“When choosing a lender, it’s crucial to compare rates, terms, and fees across different options. Look for transparency in fees, flexible payment terms, and good customer service. Many online lenders offer quick and easy applications, but it’s essential to ensure they are reputable and regulated. I always recommend reading customer reviews and ensuring the lender is a member of a recognized industry association,” says Morrisey.
Bottom Line
Understanding the pros and cons of personal loans helps you make informed borrowing decisions. While personal loans offer flexible use, fixed payments, and quick funding, they also come with fees, strict requirements, and potential credit risks. Compare multiple lenders and ensure payments fit your budget before borrowing.
Frequently Asked Questions
What credit score do I need to qualify for a personal loan?
Most lenders require a minimum credit score of 580-650, though borrowers with scores of 670+ qualify for the best rates. Some lenders work with scores as low as 500 but charge significantly higher interest rates.
Are personal loans better than credit cards for debt consolidation?
Personal loans typically offer lower fixed interest rates and set payoff dates, making them better for debt consolidation than credit cards. However, you must qualify for a rate lower than your current credit card rates to save money.
What happens if I can't make my personal loan payments?
Missing payments damages your credit score and triggers late fees. Payments 30+ days late get reported to credit bureaus, and continued delinquency can lead to collections, lawsuits, or wage garnishment depending on your state's laws.
