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One of the fundamental principles of personal finance is having six to twelve months’ worth of living expenses set aside in cash reserves to be used in the event of an emergency. The only certainty in life is that the unexpected will happen, and it can be costly.
Whether it’s the loss of a job, a big medical expense, or a major car or home repair, we can all expect a major expense at some point. But, what if you haven’t created your emergency fund? Should you use a personal loan in an emergency?
You are going to need to get the money from somewhere. If you no longer have access to “The Bank of Mom and Dad” then your best option might be to get a personal loan.
How Do Personal Loans Work?
Personal loans are unsecured loans issued based on your good credit and your signature (they are also referred to as signature loans). That means you don’t need any collateral.
However, you will need to demonstrate you are not a credit risk. With excellent credit, you can currently obtain a personal loan with an APR as low as 6%. That is considered to be a very inexpensive form of credit, much more so than credit cards, which typically have double-digit APRs.
Depending on the lender, you can borrow as much as $100,000, with terms ranging from three to seven years. The best personal loan lenders allow you to apply for a loan in just 10 minutes, receive a decision within 15 minutes and receive your funds within three to five days, so they are ideal when you need funds in a hurry.
When You Should Use a Personal Loan
Although personal loans can be a less expensive form of borrowing, you are still taking on debt, which, if you are not financially prepared, can be a burden on your finances. But, when you need a large amount of cash quickly, it can be better than using your credit cards. Just make sure you understand what a personal loan is used for, and the reason for getting one is a real emergency. A real emergency is when your life is in some way negatively impacted and only a cash infusion will fix the situation. If you have no cash or savings, a personal loan is the best option for the following types of emergencies:
- Car Repairs: This is probably the most common type of emergency that requires immediate cash. A broken transmission or timing belt can cost more than $1,500. If you need your car to get to your job, you need the money to fix it.
- Medical Expenses: The next most common emergency is an illness or accident that leads to a big medical bill. At a time when health insurance deductibles are beyond most people’s capacity to pay, a personal loan may be the only way to pay the bill. In some cases, you may be able to negotiate a medical bill to pay in installments. But, if you have a major dental procedure that needs immediate attention, you may have no other choice.
- High Interest Debt: Although this is an emergency that has been building over time, you may reach a point when your debt becomes financially debilitating. A debt spiral can only get worse unless it is completely evaporated. Getting a 10% interest personal loan to pay off a 20% interest credit card debit is a good financial move as long as you have a plan to pay it all down quickly.
- Overdue Rent or Utility Bills: If your back is against the wall with overdue rent or utility payments, a personal loan may be your only choice. However, if your financial situation is such that you are falling behind on rent or utilities, you are only buying yourself a small amount of time. You will be adding another obligation to your monthly budget which could worsen your situation.
When You Shouldn’t Use a Personal Loan
When an opportunity pops up and you’re short on cash, it’s easy to rationalize it as an emergency. It can happen when you’re invited along for a “once in a lifetime” vacation; or your renovation plans require more money than you have equity in your house. The worst thing about borrowing money for these types of emergencies is the feeling you have when you are still paying for them three or four years later.
The general rule-of-thumb when it comes to using personal loans for non-emergencies is, if you can’t pay for it with cash, you can’t afford it. Debt, no matter how inexpensive or convenient, should never be used except when it can actually improve a financial situation, such as a mortgage, college tuition, or when it can get you out of temporary financial difficulties.
Author: Jeff Gitlen