Key Takeaways
- Personal loans can be used for almost any purpose.
- Debt consolidation is the top reason people take out a personal loan, according to an Investopedia survey.
- Unlike home mortgages and car loans, personal loans are usually not secured by collateral.
- Personal loans can be less expensive than credit cards and some other types of loans but more expensive than others.
How Personal Loans Work:
A personal loan is often an unsecured loan, which means the lender does not require collateral—such as a home or car—to borrow money. However, with unsecured loans, the lender assumes more risk and would most likely demand a higher interest rate than with a secured loan. Your interest rate can be determined by a variety of criteria, including your credit score and debt-to-income ratio.
Some banks provide secured personal loans, where the collateral can be a bank account, a car, or other property. A secured personal loan may be easier to qualify for and have a somewhat lower interest rate than an unsecured loan. If you are unable to make your payments on a secured loan, you risk losing your collateral.
Even with an unsecured personal loan, failure to make timely payments can ruin your credit score and significantly restrict your capacity to receive credit in the future. FICO, the corporation behind the most frequently used credit score, claims that your payment history is the single most important consideration in its algorithm, accounting for 35% of your credit score.
When To Consider a Personal Loan
Before you opt for a personal loan, you’ll want to consider whether there may be less expensive options for you to borrow money. Some reasons for choosing a personal loan are:
- You don’t have or couldn’t qualify for a low-interest credit card.
- The credit limits on your credit cards don’t meet your current borrowing needs.
- A personal loan is your least expensive borrowing option.
- You don’t have any collateral to offer.
If you need to borrow money for a short period of time, you may want to consider a personal loan. Personal loans typically range from 12 to 60 months.
For example, if you have a lump sum of money due in two years but don’t have enough cash flow in the meanwhile, a two-year personal loan could help bridge the gap.
- Consolidating Credit Card Debt
If you have a large amount on one or more high-interest credit cards, taking out a personal loan to pay them off may save you money. For example, as of August 2024, the average credit card interest rate is 24.74%, whereas the average personal loan rate is 11.92%.
That difference should allow you to pay off the loan faster and pay less interest overall. Furthermore, paying off a single debt obligation is easier than repaying many ones.
However, a personal loan is not your only option. Instead, you might be able to transfer your balances to a new credit card with a lower interest rate if you qualify.
- Paying Off Other High-Interest Debts
A personal loan is generally more expensive than other sorts of loans, but it is not always the most expensive. For example, a payday loan is likely to have substantially higher interest rates than a bank personal loan. Similarly, if you have an older personal loan with a higher interest rate than you are eligible for today, replacing it with a new loan may save you money.
Before you replace a loan, however, be sure to find out whether there’s a prepayment penalty on the old loan or application or origination fees on the new one, which can sometimes be substantial.
3. Financing a Home Improvement or Big Purchase
If you’re buying new appliances, installing a new heater, or making another major purchase, taking out a personal loan could be cheaper than financing through the seller or putting the bill on a credit card.
However, if you have any equity built up in your home, a home-equity loan or home-equity line of credit could be less expensive still. Of course, those are both secured debts, so you’ll be putting your home on the line.
4. Paying for a Major Life Event
As with any major purchase, financing an expensive event, such as a bar or bat mitzvah, a major milestone anniversary party, or a wedding, could be less expensive if you pay for it with a personal loan rather than a credit card. According to a 2021 survey by Brides and Investopedia, one in five U.S. couples will use loans or investments to help pay for their wedding.5
As important as these events are, you may want to consider scaling costs back somewhat if it means going into debt for years to pay it off. For that same reason, borrowing to fund a vacation may not be the best idea, unless it’s the trip of a lifetime.
- Improve Your Credit Score
Taking out a personal loan and repaying it on time may help improve your credit score, particularly if you have a history of missing payments on other obligations. If your credit record shows largely credit card debt, getting a personal loan may also enhance your “credit mix.” Having several forms of loans and demonstrating that you can handle them properly is considered a plus for your score.
That said, borrowing money you don’t really need in the hope of improving your credit score is a dangerous proposition. Better to keep paying all your other bills on time while also trying to maintain a low credit utilization ratio (i.e., the amount of credit you are using at any given time compared with the amount that’s available to you).
How Do People Use Personal Loans?
Investopedia commissioned a national survey of 962 U.S. adults between Aug. 14, 2023, to Sept. 15, 2023, who had taken out a personal loan to learn how they used their loan proceeds and how they might use future personal loans. Debt consolidation was the most common reason people borrowed money, followed by home improvement and other large expenditures.
When Shouldn’t You Use a Personal Loan?
Personal loans can be used for almost any purpose, but there are a few exceptions. Most lenders will not allow you to use personal loans for the following purposes:7
- Educational expenses, including tuition, room, board, and student loan debt
- A down payment on a house
- Business expenses
- Investing
- Gambling
Note
Lenders will ask you to state the purpose of your personal loan as part of the application process.
In addition, you should avoid taking a personal loan to cover essential living needs, as this might lead to a debt spiral. Whenever possible, use revenue to pay for normal expenses to avoid debt accumulation.
Frequently Asked Questions (FAQ)
What Can I Use My Personal Loan For?
A personal loan can be used to finance practically anything, including a significant purchase or event, home upgrades, or paying down higher-interest debt or an unexpected need. However, most borrowers will not let you utilize personal loans to pay for higher education, a down payment on a home, or company expenses.
What Do I Need to Take Out a Personal Loan?
Every lender has their own specific requirements in order to apply for one of their personal loans. However, there are plenty of personal loans that are unsecured, which means you won’t need any collateral.
Can I Use a Personal Loan to Pay for Education?
Most lenders do not allow borrowers to use personal loans for higher education expenses such as tuition, lodging, and board. Many will also state that borrowers cannot utilize their personal loan products to repay college loans.
The Bottom Line
Personal loans can be useful in a variety of conditions. They are not inexpensive, though, and there may be better options. If you’re thinking about getting a personal loan, Investopedia’s calculator can help you figure out how much it would cost and whether it fits into your monthly budget.