As interest rates for personal loans tend to be lower than credit cards, you might wonder why people bother with credit cards at all? Personal loans have their own limitations, however, making them better suited for targeted spending—typically to fund unexpected expenses, home improvements, or to consolidate debt.
What is a personal loan?
Personal loans are installment loans, which means that you get a lump sum right away but you’ll have to pay fixed monthly payments and interest rates. This differs from revolving credit (i.e., a credit card), which allows you to borrow more at any time with no fixed schedule to pay off the balance (although there are small minimum payments that come with late fees).
Personal loans lump sums range from $1,000 to $50,000, to be paid back in a span of 12–60 months. Your credit score determines the interest rate, which on average is 9.5 percent, compared to about 16% for credit cards, according to Bankrate.
The downside to personal loans
- Since personal loans have fixed installments, you’ll have to pay the same payment each month without any flexibility to pay less. With less flexibility, you take on more debt risk—if you’re already using a loan to pay for an unexpected expense like a car repair, who’s to say the car won’t break down again?
- Personal loans can have lower interest rates than credit cards, but they also have significant “origination fees” rolled into the monthly payments, which can offset potential savings. These fees typically range from one percent to eight percent of the loan amount, per Nerdwallet. Make no mistake, this is money straight out of your wallet: a five percent origination fee for a $20,000 loan will cost you $1,00. (Not all lenders charge an origination fee on personal loans, but they might limit the amount you can spend).
- If you have a middling-to-poor credit score, you probably won’t get an interest rate much better than a credit card. Without the advantage of a lower interest rate, personal loans are simply a less convenient form of credit.
Before committing to a personal loan, do the math and make sure it’s right for you. In some cases, a credit card might actually be the better option, especially for smaller amounts of credit.
What personal loans are good for
Personal loans make the most sense when you have stable income and want to pay for a fixed one-time expense that you can cover with more time to pay it off. Most commonly this includes:
- Debt consolidation: You can potentially consolidate all your debts using the lower interest rate from a personal loan to save on interest charges. Ideally, this scenario allows you to pay off debt faster.
- Emergencies: If you’ve tapped out your emergency fund, a personal loan can cover unexpected car repairs or a lost computer not covered by insurance. Stay away from using personal loans for medical expenses however, as there are a number of better options you should look at first.
- Home improvement: This can be win-win as you are borrowing money to improve the value of the house, using your loan to cover the expenses. Plus, since a home equity loan exposes you to the risk of losing your property if can’t make the payments, a personal loan can be a safer option.