Personal loans can be either a useful tool for managing your finances or an opportunity to dig yourself into a dangerous financial hole. The difference between the former and latter comes from understanding the nature of this type of loan and being able to identify the most common mistakes made by borrowers.
Personal loans are short-term loans with a fixed interest rate and repayment period, issued based on your credit alone. Below are five things that everyone gets wrong about personal loans, and why avoiding these frequent mistakes is crucial for your financial health.
5 Myths About Personal Loans
1. All Personal Loans Are the Same
One of the first mistakes that is made by most borrowers is looking at all personal loans as if they’re the same. The unifying characteristic is that personal loan rates are based on your credit score and history, but there are two different types of personal loans: secured and unsecured.
Unsecured personal loans only require a signature as a guarantee of payment, whereas a secured personal loan also requires some sort of collateral — much like a mortgage or car loan does. The advantage of unsecured loans, of course, is that there are no hard assets to be seized if you default; at the same time, that likely means you’ll have to pay a higher interest rate, as the lender will be assuming a greater level of risk by giving you the loan.
2. Personal Loans Are Always a Better Option Than Credit Cards
While it is true that in some cases, personal loans can carry lower interest rates than credit cards, there are still tradeoffs. For example, peer-to-peer lending app Prosper offers personal loans that start at 6.68% APR, while the national average for credit card rates is a little under 15% APR, according to CreditCards.com — but this is only a part of the story. Many personal loans have a minimum term of five or six years, which can mean that the amount you pay in interest over the life of loan could eclipse the interest you pay on shorter-termed loans.
3. You Should Apply For a Larger Loan Than Needed
Another common mistake that many borrowers make is applying for a larger loan than they actually need. You might think that this allows the bank to come back with an offer for a lower amount, but the lender’s decision will be based on its assessment of your ability to repay the debt. If you reach too high — without having the income, work history and credit score to back it up — you could simply be turned down.
Additionally, the bigger the loan you take out, the more interest you’ll end up paying. Don’t commit your future self to being in the hole to a gargantuan loan you didn’t actually need.
4. A Personal Loan Will Automatically Improve Your Credit
The logic behind this misconception is that if you get a personal loan and use it to close most of your credit card accounts, you will improve your overall credit rating. There are elements of accuracy in this one: Because a personal loan is considered installment (not revolving) debt, it’s not factored into your credit utilization ratio, while credit card debt is. Consolidate your credit card debt in a personal loan, and you could immediately boost your credit score — and get an interest rate lower than most credit cards can offer.
However — and it’s a big ‘however’ — if you don’t have enough money to pay off the debt regardless, this strategy will make little difference. Missing a payment on a personal loan is just as damaging, if not more; what’s more, because personal loans have typically shorter terms, your payments will likely be larger and harder to manage. Keep this in mind if you’re considering consolidating your credit card debt in this manner.
5. You Can Only Get a Personal Loan With Great Credit
Even though it is more difficult to get a personal loan if you have adverse items on your credit report, it is not impossible. GOBankingRates has identified five loans you can qualify for even if you have bad credit. While any loan will be carefully considered before it is accepted, loans from credit unions, peer-to-peer lenders and family members are more viable options if your credit is less than great.