The envelope promises so much when it arrives in the mail.
“Live debt-free and get what you want at the same time,” the note inside whispers. Pay off those high-interest credit card balances. Get the new kitchen you’ve been dreaming of! Take that vacation, or pay for your wedding — and you can have the cash in your account in just a few short days.
What could be better — right?
Personal loans are the fastest-growing type of debt in America, according to a 2019 study by Experian. Baby boomers are the worst offenders, with the highest balances averaging over $200,000. And although only 10.8% of adults have a personal loan, this type of debt is growing twice as fast as credit card debt.
What is a personal loan?
A personal loan is an installment loan that doesn’t require collateral but often charges an origination fee. These loans typically offer fixed interest rates and payments over a period of years. Consumers frequently use personal loans to consolidate high-interest credit card debt or pay for big expenses.
It’s easy to understand why consumers find personal loans appealing. First, these loans typically offer lower interest rates than credit cards. Second is flexibility: Lenders deliver loan proceeds in cash, often within a few days. Finally, because personal loans are installment loans, the borrower knows exactly how much they’ll pay every month and for how long.
“This is an expensive source of money if you don’t pay it off quickly, but it is accessible and convenient,” says John Sweeney, head of Wealth and Asset Management at Figure. “Personal loans are often a bit cheaper [than credit cards], typically have a payment structure that’s a few years, and can be used to pay off a slightly bigger one-time expenditure,” he says.
When is a personal loan not the best choice?
On paper, a personal loan can sound like a smart choice. And according to some financial advisors, it can be — but only in limited cases.
“[I had] a client that had about $10,000 of credit card debt. They were initially paying the minimum amount, and were very serious about repaying the debt back,” says financial planner Nico Felipe, founder of Vantage Planning. “We applied for a personal loan [and] he was able to get an interest rate one-fourth of their credit card,” he adds.
Most financial advisors we asked, however, remained skeptical that these loans are a smart move.
“As a consumer-facing wealth advisory practice we have rarely, if ever, recommended a personal loan,” says Tyler Lerman, a financial advisor with Janney Montgomery Scott.
Here are six occasions when taking out a personal loan may be unwise:
You want to take a vacation
Don’t take out a personal loan lightly, Sweeney says. “Borrowing money can be a powerful way to reach your financial and personal goals, but you want to make sure you're borrowing for the right reasons from the right source, and have a disciplined budget in place to be able to repay that loan,” he says. In other words, if the loan isn’t mission-critical to your long-term financial goals (as much as that trip to Cabo might mean for your mental health), don’t do it.
You want to buy a car
Auto dealers frequently offer special financing opportunities with interest rates far lower than personal loan rates, simply because an auto loan is a collateralized debt. “Due to the no-collateral aspect of the [personal] loan, typically interest rates are extremely high,” Lerman says.
You want to go to school
Taking out a personal loan to pay for education expenses isn’t just unwise because it's an expensive way to borrow; you also lose a host of legal protections and financial benefits.
For example, if you qualify for a subsidized student loan, you can avoid paying interest on the amount you borrow while you’re in school on at least a half-time basis. Consolidating student loans is easier, too. And if you have trouble repaying them, you could potentially postpone payments or restructure the terms. Planning to work in public service? You might even qualify for loan forgiveness — and that’s a pretty huge deal.
How many of those protections do you get with a personal loan? None.
You’re struggling to make ends meet
Matthew Gaffey, a Senior Wealth Manager at Corbett Road Investment Management, notes, “The best time to apply for any loan is a time in which you don’t need the money. To explain further, banks [and] lenders aren’t excited to go out of their way to loan someone money who is in a tight spot and has a lower likelihood of being able to pay off the debt.”
You want to renovate your home
A home equity line of credit or loan lets you borrow against your home’s value. “Home equity lines of credit (HELOCs) are great for flexibility, as you choose the repayment terms. With both home equity loans and HELOCs, you will often have a lower interest rate than with personal loans,” Felipe says.
You have poor credit
Although some financial advisors mentioned that a personal loan can help a consumer raise their credit score, most said the high-interest rates charged by lenders are too costly to make the risk worth it. That’s especially true if you have fair or poor credit when you apply because lenders charge higher interest rates to customers who are a bigger credit risk.
Higher interest rates mean higher payments, and higher payments are harder to pay. If you fail to meet the new loan’s obligations, then you put your score at further risk.
What are some alternatives to a personal loan?
While personal loans can help people pay off high-interest debt faster, “a personal loan can cause harm if an individual is taking on additional debt at higher interest rates to service expenses that are unnecessary,” says Ali Hashemian, Certified Financial Planner, author, and President of Kinetic Financial.
The good news is that there are several alternatives to consider.
Open a savings account
If you need money for a non-essential expense such as a vacation, a high-yield savings account might be just the ticket. In other words, instead of paying back a lender, you’ll pay yourself forward as interest accumulates in your account. As you add to your savings account balance, the amount you earn in compounding interest will accelerate. The only difference is that you’ll get what you want after you’ve saved up.
Although it’s true that you won’t get the quick satisfaction that loan proceeds provide, you also won’t overpay — and in case you need emergency funds along the way, you’ll have them. And that can prevent you from going into debt.
Decide if you want to borrow against your house
This is a tough call. Most advisors we asked said it’s a great option — up to a point. If you’re using home equity to reinvest in your home, that’s one thing. But if you want to use your house as a “piggy bank,” says Sweeney, that’s another matter entirely.
Explore balance transfer and no-interest options
If you have a credit card with no balance and the issuer offers a no-interest balance transfer option, this might be the better way to go. But again, experts say, exercise caution. Failure to repay the full balance during the promotional period means you could wind up paying 18% or more on what’s left.
Negotiate with your lender
If you’re struggling to make ends meet and don’t have good enough credit for a balance transfer credit card or another type of low-interest loan, call your lenders. You might be surprised to learn that they’re willing to help you make your repayment terms more affordable.
One last word of caution
Long story short, the financial products that promise quick solutions to debt and spending challenges sometimes create more problems than they solve. If you’re concerned that you’ll run up more debt on the credit cards you just paid off or you’re thinking of using personal loan proceeds for non-essential expenses, it may be time to reevaluate your approach.
“I have had clients use personal loans that help their debt positions,” says Hashemian. “I also have a client that considered using a personal loan to buy a vintage video game collection. If you are going to use a personal loan, make sure it is for the right reasons.”
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