When you weigh the cost and benefits, personal loans are a smart play in these three scenarios.
Personal loans are one of the most versatile types of loans because you can use them for just about anything. But the fact that they don’t require any collateral means that they aren’t always the most affordable option. Since lenders have nothing to seize if you fail to pay back what you owe, they charge you higher interest rates. So while you can theoretically use a personal loan for anything, that doesn’t mean it’s always your best choice.
You should never take out a personal loan — or any debt for that matter — for frivolous things like vacations because it’s just costing you money without giving you any long-term benefits. But there are scenarios where a personal loan can make a lot of sense. Here are three of them.
1. You want to consolidate high-interest debt
One of the best and most popular uses for personal loans is paying off high-interest debt like credit card debt or payday loans. The reason this makes sense is because the interest rates on personal loans can be much lower than on these other types of debt. If you keep spending on the credit card or taking out new payday loans to cover your old ones, your balance could grow over time instead of shrink.
A personal loan can end this by getting you a predictable monthly payment and a balance that won’t grow any larger. This simple change helps many people finally begin to pay down their high-interest debt — sometimes debt they’ve carried for years.
Using a personal loan to pay down credit card debt can also have unexpected benefits, like raising your credit score. A big part of your credit score is your credit utilization ratio, which is the ratio between the amount of credit you use each month compared to the amount you have available to you. Using more than 30% of your available credit each month is considered a sign of living beyond your means and can negatively affect your chances of securing other loans or lines of credit in the future.
When you use a personal loan to pay off your credit card debt, your credit utilization ratio will drop and your credit score will rise accordingly. But you must be careful not to rack up new charges on your credit card that you can’t pay back or you’ll end up worse off than before.
2. You want to make some improvements to your home
There are other types of loans you can take out to make improvements to your home, including a home equity loan. But if you don’t have a lot of equity in your home yet or you don’t want to borrow against it, a personal loan is another option.
You can use a personal loan to do just about anything to your home, but if you want to make it worthwhile, use the money to do things that will add to the value of your home, like adding a new bathroom or remodeling a kitchen. When you go to sell your home, you will hopefully get back at least some of the money you put into it.
It’s fine to use some of the money to make other upgrades that won’t affect the value of the home as much, but you should understand that you might not get this money back if you attempt to sell the home someday.
3. You want to finance a large purchase without relying on credit cards
As I mentioned above, charging too much to your credit cards can be problematic due to their high interest rates. So some people rely on personal loans when they need to finance a large purchase rather than risk falling into credit card debt.
Obviously, it’s better if you can avoid taking on debt at all and save up for these large expenses on your own. Budget a certain amount each month for planned expenses and build up an emergency fund to help cover any unplanned expenses. But if you haven’t done this and a sudden expense comes up, like a major car repair, taking out a personal loan to cover it is smarter than charging that bill to a credit card. At least a personal loan will give you a predictable payment and a loan term with a guaranteed end date, unlike credit cards.
Personal loans have their place, but they’re not the best choice for every situation. If one of the three above scenarios applies to you, a personal loan might be a good fit. Otherwise, work on building up your own personal savings and emergency fund to help you cover your expenses without taking on debt.
