Are Personal Loans Bad? What You Should Know Before Borrowing

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Personal loans aren’t bad if used responsibly. They can be a helpful source of financing for qualified borrowers, given they often carry lower interest rates than credit cards. Still, personal loans increase your debt, which does have some risks. 

For example, if you can’t honor your loan agreement, you may be charged additional fees and risk damaging your credit. You can also put your overall financial health in trouble if you’re borrowing money just to make ends meet.

What Is a Personal Loan? 

A personal loan is a lump sum borrowed from a bank, credit union online lender or other financial institution. They’re installment loans, meaning you repay your lender with set monthly payments at a fixed interest rate over a select period of time — for example, between one to five years.

Personal loans can be used to cover the cost of many different expenses, but some of the most common include:

• Home improvement projects
• Medical expenses
• Car repairs
• Debt consolidation

You can’t use a personal loan for everything, though. Some exceptions include college tuition, gambling or investments.

Pros vs. Cons: When Is a Loan a Good or Bad Idea? 

Once you have the full picture of the pros and cons of a personal loan, you’ll be better able to determine if it’s a good or bad idea for your finances.

4 Personal Loan Benefits

Low Interest Rates for Qualified Borrowers

The latest Federal Reserve research puts the average interest rate on a 24-month personal bank loan at 11.57%, while the average credit card annual percentage rate (APR) runs much higher at 21.16%.

Borrowers with good-to-excellent credit can often qualify for a personal loan in the high single digits — somewhere between 7% to 9%. That’s why personal loans are often used to combine and pay off high-interest credit card debt with debt consolidation.

Predictable Payments

Most personal loans have fixed interest rates, which means your APR stays the same throughout the loan.

You also can’t increase the loan balance or spend beyond the original amount, so you’ll know exactly how much you owe each month.

Funding for Necessary Expenses

Since personal loans can have low interest rates and a predictable payment schedule, they’re often one of your better options if you can’t avoid borrowing.

“Sometimes, consumers will still need to borrow to correct a situation,” said Michael Sullivan, a personal finance consultant with credit counseling agency Take Charge America. “They should always seek the lowest interest rate and the shortest repayment time possible within their budget constraints. Sometimes, for consumers with even less advantageous debts, this will involve taking out a personal loan.”

Potential Credit Score Increases

Being consistent and on-time with your personal loan payments will improve your payment history, which is the leading factor in determining your credit score.

Personal loans can also improve your credit mix, especially if you didn’t have other types, like a credit card, before taking out the loan. Lenders like seeing that you can manage multiple different types of credit. prefer to see that you manage multiple types of credit. 

Risks and Disadvantages of a Personal Loan 

High Interest Rates for Borrowers With Subpar Credit

Personal loans can have low APRs, but not everyone can qualify for the best terms. Plus, applicants with so-so or poor credit who are approved will likely see APRs at the top end of the lender’s spectrum, which can reach up to around 36%.

Extra Fees

Some personal loans charge an origination fee between 0.5% and 1% of the loan amount or prepayment penalties, which are around 2% of your balance. Other fees, like late payment or insufficient funds, might also increase your cost to borrow.

Strains on Your Budget

A fixed monthly payment can be difficult to manage if your income is unstable or your financial situation changes unexpectedly. “Personal loans offer little flexibility in repayment since they are typically at a fixed interest rate for a fixed period of time,” Sullivan said. “The payments are just like rent and utilities; they need to be made regularly.”

Potential Credit Consequences

You can incur short-term credit score damage as a result of a personal loan, since the financing increases your outstanding debts, lowers your credit age, and adds a hard inquiry to your credit report. If you mismanage the loan by skipping payments and accumulating late fees, you risk harming your long-term creditworthiness.

Can Encourage Unnecessary Spending

Unnecessary spending can create or worsen debt issues, and you want to ensure you’re not using a personal loan as a bandage for bad spending habits.

“Borrowing money for any purchase that can’t generate a return or at least result in savings greater than the cost of the loan is irresponsible,” Sullivan said. “Consumers should recognize that they need help if they can’t manage day-to-day financial affairs without borrowing.”

Alternatives To Personal Loans To Consider 

“The first, and best, option is to see if you can pay down your own debt with the help of a good budget and either the avalanche or snowball method,” said Enright.

If do-it-yourself (DIY) debt repayment strategies won’t suffice, consider these personal loan alternatives. 

0% Intro APR Credit Card 

These cards offer a 0% APR for some time, usually 12 to 24 months, on new purchases and balance transfers. They’re a good option if you can pay the balance off in the allotted time, as that allows you to avoid interest entirely. 

Credit Counseling or Debt Management Plans 

A good option if you need external help getting out of the red, credit counseling agencies provide free financial advice and, for a fee, will set up a debt management plan (DMP). DMPs consolidate debts into one monthly payment made to the credit counselor, who disburses the funds to your creditors as agreed. Ideally, the counselor has negotiated lower balances or interest rates.   

Buy Now, Pay Later Plans 

Buy Now, Pay Later (BNPL) programs offer short-term financing for select purchases, often at checkout. These programs generally let you skip or pay low interest, so long as you repay the loan on time. However, they sometimes carry extra fees and should only be used when absolutely necessary. In other words, don’t let the financing offer entice you to buy something you don’t need or ultimately can’t afford. 

Advance Savings

If you know a big purchase or expense is on the horizon, consider ramping up your savings to avoid borrowing funds. You can find ways to fund your emergency savings — launching a side hustle, selling gently used goods, and pausing or canceling monthly subscriptions, as examples.

How To Borrow a Personal Loan the Smart Way 

Consider these steps if you believe a personal loan is right for you. 

1. Check your credit to get a better idea of what interest rates and terms you might qualify for. Keep in mind that lenders generally require very good to excellent credit, a FICO score of 740 or higher,for their best advertised offers. 
2. Borrow only what you need and can afford to repay. Otherwise, taking on a personal loan can lead to larger financial issues. Consider using an online calculator to determine estimated monthly payments based on APRs and repayment periods. Many lenders have these tools directly on their website.  
3. Compare fees, terms and repayment timelines to find the best available offer for your credit profile. Consider prequalification — a process in which the financial institution runs a soft credit check to determine approval odds, rate, and term estimates — to get a clearer comparison. Soft credit checks won’t impact your credit score.
4. Have a solid repayment plan so you can avoid using the personal loan for any unnecessary spending. Plus, make sure you have a plan to make all payments on time, said Kyle Enright, president of lending at Achieve. Utilize tools like autopay to avoid undue damage to your credit score.

Ultimately, make sure that borrowing money supports your financial goals and doesn’t set you back. Taking on debt isn’t necessarily bad if you’re using it in a way that benefits you.

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