Pros and Cons of Personal Loans: Key Things to Know

Provide Flexibility to Cover Almost Any Purpose

Personal loans stand out for their flexibility, which allows borrowers to use them for various purposes without the limitations often found in auto loans or mortgages, which must only be used for a car or home purchase, respectively.

For example, a personal loan can finance a wedding, support home improvement projects, consolidate high-interest credit card debts or cover medical emergencies, home improvements and travel expenses. This makes personal loans valuable for individuals seeking a single financial product to meet diverse needs. Be prepared to disclose the purpose of the loan. Some lenders have restrictions on what the funds can be used for.

Offer Competitive Interest Rates

According to the Federal Reserve, the average interest rate for a 24-month personal loan is 12.49% as of February 2024, which is much lower than the average credit card rate of 21.59%. You may secure lower rates for a personal loan if you have a high credit score.

Say you’re looking to borrow $10,000. Opting for a 24-month personal loan at a 12.49% interest rate instead of using a credit card at 21.59% can save you over $1,000 in interest payments across the life of the loan.

Offer Higher Borrowing Limits

Personal loans typically range from $1,000 to $100,000, allowing you to fund high-cost projects, such as kitchen renovations or debt consolidation.

However, the amount you can borrow with a personal loan varies by lender and is influenced by factors such as your credit score and income. You can increase your chances of qualifying for the higher end of borrowing limits if you have a good credit score and a solid income.

Give Access to Cash Without Collateral

Most personal loans are unsecured, meaning they do not require collateral, which lenders take if you default on payments. This removes the risk of losing valuable assets, making them a safer financial option for many borrowers.

Without collateral, the approval for unsecured personal loans depends on the borrower’s financial profile, which includes credit history, proof of income, debt-to-income (DTI) ratio and more. This allows those with strong financial backgrounds to access funds, often with more favorable terms.

Improve Credit Score

Credit scores are calculated based on several factors, including your payment history, the amounts owed on debts, the length of your credit history, new credit and the types of credit in use.

Obtaining a personal loan can contribute positively to your credit score by improving your credit mix and establishing a history of timely payments. Consolidating credit card debt with a personal loan can reduce your credit utilization ratio, which is the amount of credit you're using compared to your total credit limit.

Offer Quick Funding

The application process and funding time for personal loans can differ from one lender to another. Many lenders advertise fast loan decisions, with some providing same-day or next-day funding.

With a personal loan, borrowers can access the funds they need with minimal hassle as applying is typically an easy and straightforward process. While the exact requirements may vary across lenders, most will request a completed application form, proof of identity, income verification and address verification.

Make Budgeting Easier

Personal loans offer repayment terms that range from 12 to 60 months, with some lenders even willing to extend the repayment period beyond this average. This wide range of options provides borrowers with the flexibility to select a repayment schedule that best fits their financial situation.

Additionally, most personal loans provide a fixed repayment schedule, making it easier to incorporate loan payments into monthly financial planning. By knowing the exact amount due each month and the duration of the repayment period, you can allocate funds effectively.

Carry High Interest Rates

Low interest rates are not guaranteed with personal loans. The rate you receive is largely determined by your creditworthiness, which includes your credit score, income, and debt-to-income ratio. As a result, having a lower credit score can lead to being charged a higher interest rate.

Charge Additional Fees and Penalties

Personal loans can come with additional fees that contribute to the overall cost of borrowing. These include origination fees, which are charged for processing the loan application and are typically a percentage of the loan amount, and late fees, which are incurred when a loan payment is made after the due date.

Some lenders may also charge you with prepayment penalties if you pay off your loan early to compensate for the interest they will miss out on and returned check fees if your payment check is returned due to insufficient funds. It’s important to review the fine print of your loan agreement and consult with your lender for specific questions about terms.

Increase Debt Over Time

While a personal loan can provide immediate financial relief or enable you to make a necessary purchase, the accumulation of interest and potential fees add to the total amount you owe. If not managed properly, this can lead to a cycle of borrowing and repayment that increases your overall debt, potentially making it more challenging to secure future credit.

Hurt Your Credit Score

A personal loan can impact your credit score negatively if not handled responsibly. Missed or late payments are reported to credit bureaus, leading to a drop in your credit score. Additionally, applying for a new loan results in a hard inquiry on your credit report, which can also temporarily lower your score.

Require Collateral

Personal loans come in two types: unsecured, which don't require collateral, and secured, which do. Borrowers with lower credit scores may find themselves needing to secure a loan with an asset, as lenders seek assurance against the risk of non-payment.

Assets that can be used as collateral include savings accounts, real estate, vehicles or insurance policies. Should you default on a secured personal loan, the lending institution has the right to seize the asset pledged as collateral to recover the owed amount