Are Personal Loans Bad?

When you need money to cover unexpected or large expenses, a personal loan can fill the financial gap. But before you start apply, it pays to have a thorough idea of what you're getting into. Here, we'll cover some of the questions you may have as a borrower and offer some fresh ideas to help you make the best possible decision.

Are personal loans bad?

No, personal loans are not bad. Personal loans can help you make improvements to your home, cover emergency expenses, or consolidate existing debt at a lower interest rate. A personal loan can even improve your credit score. But a personal loan is not a good idea if you think you will have trouble making the monthly payments.

Is a personal loan bad for your credit score?

No. As long as you're a careful borrower, a loan can help improve your credit score. Here's why:

A personal loan is not bad for your credit score as long as you make all monthly payments as agreed. In fact, making all payments in full and on time can raise your credit score.

You can, however, damage your credit score if you add a personal loan to a pile of other debts. That's because the more you owe to creditors and lenders, the higher your debt-to-income (DTI) ratio -- a mathematical equation used by lenders to determine how much of your monthly income is eaten up by debt.

An exception to this concern is when you take out a debt consolidation loan. We'll discuss how consolidating existing debt impacts your credit score in a moment.

5 times getting a personal loan is a good idea

If it's true that there is a time for everything, personal loans are no exception. Here are five times taking out a personal loan may be the best thing to do.

1. To consolidate high-interest debt, like credit cards

How it works: Personal loan interest rates are generally lower than credit cards. When you take out a debt consolidation loan with a lower interest rate than you're currently paying for other debt, you will pay less interest and save money. Also, your monthly payment may be lower.

Let's say you have three credit cards and owe a total of $10,000. Each card carries an interest rate of 16.99%. If you want to pay them off in 36 months, here's how much you'd pay each month along with how much you'll pay in total interest:

If you took out a personal loan with an interest rate of 9.5%, here's what you'd pay instead over a loan term of 36 months:

Using a consolidation loan, you would save a total of $1,321 in interest and have a lower monthly payment.

That's how a debt consolidation loan can help you wipe out high-interest credit card debt. As long as you aren't racking up new charges and debt on the credit cards while you're paying off your loan, your credit score will benefit.

2. To increase your credit score

How it works: When the balance you owe on a credit card is higher than the available credit you can spend, this can impact your credit score negatively.

If you have a credit card with a $6,000 limit and have spent $3,000, you have a credit utilization ratio of 50%.

Personal loan lenders tend to think people who keep their credit utilization ratio under 30% do a better job of managing their credit. That's why the higher your credit utilization ratio (the closer you are to maxing out your credit cards), the lower your credit score.

Take a look at what the balances on these three credit cards do to a credit utilization ratio:

If you used a personal loan to consolidate the above credit card debt, your utilization ratio would immediately drop to 50%:

Even though your utilization ratio is 100% for your loan, your other credit cards are at 0% -- so your overall ratio goes down.

Just by increasing your available credit, you can improve your credit utilization ratio and credit score. And as you pay the loan down, things will only get better.

3. To make home improvements

How it works: Some home improvement projects like wood floors and a new HVAC system can increase the value of your home. Even if you don't plan to sell your property anytime soon, a personal loan for home renovations can allow you to make your house more valuable.

4. To build credit history

How it works: For people who have bad credit or are just starting to build their credit, consistently making payments on a personal loan is an easy way to build a positive credit history and plump up your credit score. Building toward an excellent credit score is a worthy goal. Having excellent credit means easier loan approval when you need a new loan and the ability to avoid high interest rates or predatory lenders.

5. To establish credit in your own name

How it works: When you're newly single, a personal loan can be a win/win situation. A personal loan can fund a dream project (like creating a spa-like master bath or garden of your dreams) and help you establish your own credit. Some personal loan lenders offer low loan amounts, which is a good thing if the primary reason you want an installment loan is to make a regular monthly payment and build excellent credit on your own.

3 times getting a personal loan is a bad idea

Like all financial products, personal loans can be a powerful tool. They can also be, on occasion, a bad idea. Here are three times when a personal loan is not your best option.

1. When it cuts your budget too close for comfort

Try this instead: Wait until your financial picture has time to improve.

If your budget is already tight, think twice about taking out a personal loan, even if you have already filled out a loan application and received loan approval. Unless a personal loan allows you to rid yourself of existing debt with a higher interest rate, a new loan might just add to your financial burden. If possible, find another way to get the cash you need. This may include borrowing from family or friends or selling things around the house you no longer use.

2. When you don't have an emergency fund in place

Try this instead: Unless the loan is intended to cover an emergency, focus on building an emergency fund.

One of the most predictable things about life is how unpredictable it can be. That's why it helps to have an emergency fund with three to six months' worth of income. That way, you're able to cover large and unexpected expenses like car repairs or medical bills. So if the reason you're considering a personal loan can be delayed, consider doing so until you have an emergency fund in place.

3. When your credit score is not up to snuff

Try this instead: Take steps to improve your credit score until you can qualify for a personal loan with a low interest rate.

While there are credible lenders that offer bad credit personal loans, the interest rate is higher than you would pay if you had a strong credit score. You may also be required to pay more in fees. More importantly, taking on a new debt when your credit score needs boosting may add unnecessary stress to your life.

Still, life happens and you may not have much choice if you find yourself in an emergency situation. Ideally -- even if you do pay more for this loan -- making each monthly loan payment on time will help increase your credit score.

The benefits of a personal loan far outweigh the drawbacks, particularly if you have an excellent credit score and a plan for using the funds in a way that improves your financial outlook. It helps to think of a personal loan as a financial tool and to pull it out of the toolbox when you have a specific job for it to accomplish.