Pros and Cons of Personal Loans

Personal loans are financial products providing individuals with lump-sum funds for many purposes. They are often unsecured and repaid over a fixed term with interest. Evaluating the advantages and disadvantages of personal loans is critical to making informed financial decisions. 

We’ll explore the benefits and drawbacks of personal loans, alternatives to consider, and how to determine whether a personal loan is the right choice for your financial needs. You’ll find out the most important factors to consider when pursuing this financing option.

Personal loan pros and cons

Personal loans are a popular financing option offering borrowers quick access to funds for various needs. Whether it’s consolidating debt, making home improvements, or covering unexpected expenses, personal loans provide flexibility and convenience. 

However, like any financial product, they come with advantages and disadvantages.

Pros

• Quick access to cash

• Flexible use of funds

• Fixed interest rates

• No collateral required

• Lower rates with good credit

• Simple application process

Cons

• Potential for high fees

• Limited options for poor credit

• Impact on debt-to-income ratio and credit score

• Risk of impulse spending

• Repayment period may be short

• Possibility of prepayment penalties

Here’s more about each aspect listed above.

Pro: Quick access to cash

Many personal loans offer a speedy approval process, providing borrowers quick access to cash. The fast approval and funding speed can be beneficial in emergencies or urgent financial situations where immediate access to cash is necessary.

Pro: Flexible use of funds

Many other types of installment loans are specific to certain purchases or assets (such as auto loans or mortgages), but personal loans offer flexibility in how you can use the funds. 

Borrowers can usually use personal loan proceeds for nearly any purpose, including debt consolidation, home improvements, or medical expenses.

Pro: Fixed interest rates

In many cases, personal loans have fixed interest rates, meaning the rate remains unchanged throughout the loan term. This gives borrowers predictability and stability in their monthly payments, making budgeting easier and protecting against sudden increases in interest rates.

Pro: No collateral required

Most personal loans are unsecured, meaning borrowers don’t need to put up collateral, such as a house or car, to secure the loan. Because you don’t pledge collateral to the lender, you won’t risk losing the asset if you can’t repay the loan as agreed. 

The absence of collateral makes the loan application and approval process faster.

Pro: Lower rates with good credit

Borrowers with good-to-excellent credit scores may qualify for lower interest rates on personal loans. A lower rate can reduce the overall cost of borrowing, resulting in monetary savings over the life of the loan. 

This incentive encourages borrowers to maintain good credit habits and improve their financial outlook in the long run.

Pro: Simple application process

Personal loans often come with a simple online application process, allowing borrowers to apply quickly. With little paperwork and straightforward eligibility requirements, borrowers can often complete the application process in a matter of minutes. 

This simplicity saves time and reduces stress for applicants, making personal loans an accessible option for those needing quick financial assistance.

Con: Potential for high fees

Personal loans offer fast access to cash, but they may come with various fees, such as origination, application, and late payment fees. These fees can increase the overall borrowing cost, so be sure you understand the fee structure before taking out a personal loan. 

Review the terms and conditions of the loan agreement, and see whether you qualify for a no-fee personal loan.

Con: Limited options for poor credit

Individuals with poor credit may struggle to qualify for personal loans or may only be eligible for loans with high interest rates and less favorable terms. This limited access to financing options can make it difficult to address financial needs or emergencies. 

However, borrowers with poor credit can work on improving their credit score over time to qualify for better loan terms in the future.

Con: Impact on DTI and credit score

Taking out a personal loan increases an individual’s overall debt load, which can affect their debt-to-income ratio (DTI). A high DTI may make qualifying for future loans or credit lines challenging because lenders might view the borrower as a higher credit risk. 

Defaulting on any loan can harm the borrower’s credit score, making it harder to obtain favorable terms on future credit products. Consider the effect of a personal loan on your overall financial health before proceeding with the application.

Con: Risk of impulse spending

Because getting a personal loan is easier than many other types of loans, borrowers may succumb to impulse spending and use the loan for nonessential purchases. This can lead to unnecessary debt accumulation and financial strain if the borrower struggles to repay the loan. 

Exercise caution, and only use personal loans for essential expenses or planned financial goals, so you avoid debt traps.

Con: Repayment period may be short

Repayment terms for personal loans can range from a few months to several years. The short duration of these terms is due to the absence of collateral. Lenders aim for prompt repayment. 

A shorter repayment term may reduce interest costs over the loan’s duration, but it also entails larger monthly payments. This trade-off can pose a challenge for individuals with tight budgets. 

Consider your budgetary needs and financial goals when choosing a repayment term, weighing the benefit of reduced interest against the drawback of larger payments.

Con: Possibility of prepayment penalties

Depending on the lender, some personal loans may come with prepayment penalties, which are fees lenders charge to borrowers who pay off their loan balance before the scheduled repayment term ends. 

These penalties can negate the potential benefits of paying off the loan early and may deter borrowers from making additional payments to reduce their debt. 

It’s essential to review the personal loan’s terms to understand whether prepayment penalties apply and how they may affect your repayment strategy.

Is a personal loan right for you?

Determining whether a personal loan is right for you requires careful consideration. Before deciding, assess your financial situation, borrowing needs, and the potential impact of a personal loan on your overall financial health.

Here’s a guide to help you decide:

Consider a personal loan if…	Reconsider a personal loan if…
✅ It’s for debt consolidation	❌ Interest rates are higher than alternatives
✅ It’s for emergency expenses	❌ Credit score impact could hurt your chances of approval for a loan you plan to apply for soon
✅ It’s for home improvements	❌ You risk overborrowing
✅ You need quick funding	❌ The lender charges prepayment penalties

This is why we do and don’t recommend a personal loan in each situation.

Reasons to consider a personal loan

• Debt consolidation: For those with multiple high-interest debts, consider a personal loan to consolidate them into a single loan with a lower interest rate. This simplifies repayment and could save you money on interest payments.
• Emergency expenses: When faced with unexpected financial emergencies, such as auto repairs or medical bills, a personal loan provides quick access to funds when savings fall short. Plus, interest rates tend to be lower with personal loans than on revolving debt, such as credit cards. 
• Home improvements: Planning home renovations? Consider funding them with a personal loan to enhance your living space or increase property value without tapping into home equity.
• Quick funding: A personal loan can provide quick financial relief if you need fast access to cash for urgent expenses or opportunities.

Reasons to reconsider a personal loan

• High interest rates: If the interest rates are much higher than alternative financing options, assess whether the cost of borrowing outweighs the benefits.
• Credit score impact: If you plan to apply for another loan soon and want to avoid a temporary dip in your credit score, reconsider taking out a personal loan. Applying for any new credit can cause a short-term credit score decrease due to lenders’ hard inquiry.
• Risk of overborrowing: Evaluate the risk of accumulating excessive debt before obtaining a personal loan. Ensure repayments are manageable within your budget to avoid financial strain.
• Prepayment penalties: If prepayment penalties are involved, reconsider. Understand the terms to avoid extra costs if you pay off the loan early.

Our expert’s advice

Erin Kinkade

CFP®

Make sure the payments fit your budget and still allow room for discretionary spending and saving. If the loan tightens your budget too much, you may want to apply for a lower amount or wait until interest rates are lower. The Federal Reserve said it intends to begin to cut interest rates, possibly beginning in June 2024. If you can wait, I recommend it. However, a June rate cut is not guaranteed, so waiting until an actual rate cut occurs is my recommendation. Keep abreast of current rates. 

Alternatives to a personal loan

If the cons of a personal loan outweigh the pros or it’s not the right financial choice, several alternatives exist. Here are five options:

1. Credit cards: Spending with a credit card may be more suitable for smaller expenses or short-term borrowing. Many credit cards offer promotional periods with low or no interest rates, providing a temporary borrowing solution without a separate loan application.
2. Home equity line of credit (HELOC): If you’re a homeowner with equity, a HELOC allows you to borrow against your home’s value for larger expenses, such as home improvements or debt consolidation. It may have lower rates than a personal loan, but getting one takes more time.
3. 401(k) loan: For those with retirement savings, such as a 401(k), you may be able to borrow against it. This option allows you to access quick funds without a credit check, but it’s essential to evaluate the impact on your retirement savings and the risk of penalties for early withdrawal if you leave your job or are terminated.
4. Negotiate with creditors: If you’re struggling with debt payments, consider negotiating with your creditors for more favorable terms. Many creditors are willing to work with borrowers to develop alternative repayment plans, which may include reduced interest rates or extended payment deadlines.
5. Emergency savings fund: Creating a fund for emergencies offers a financial safety net for unexpected expenses, reducing the need to borrow. Begin by setting aside part of your monthly income until you’ve built up savings to cover several months’ living expenses. Our experts recommend saving three to six months’ worth of living expenses.  This includes all expenses to allow you to maintain your standard of living, but consider cutting out expenses you can do without.

When weighing your options, consider the rates, terms, and potential impact on your financial situation. Select the personal loan alternative that best fits your long-term goals and is well-suited to help you fill your financial needs.