by Kailey Hagen | Oct. 17, 2019
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Taking out a personal loan for the wrong reasons could come back to haunt you in more ways than one.
When you're strapped for cash, a personal loan seems appealing. You don't have to put up any collateral and you can use the money for just about anything you want. Even individuals with poor credit might be approved. But like all loans, personal loans have some drawbacks as well.
Interest rates are typically higher than they are on secured loans and if you fail to pay the money back on time, it could hurt your ability to take out new loans in the future. Here are five times when a personal loan just doesn't make sense.
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Secured loans require collateral, which is something the bank can seize if you fail to pay back what you owe. Your collateral is your car in an auto loan or your home in a mortgage. Personal loans have higher interest rates because they don't require collateral. That means there's nothing the bank can take if you fail to pay back the loan, so it charges you more in interest to compensate for the increased risk.
There's no rule saying you can't use a personal loan to buy a car or a home, but if your aim is to pay the least in interest possible, you're better off going with an auto loan or mortgage. Personal loan interest rates typically vary from around 14% to 30%, depending on your credit. The average auto loan APR is only 4.21% for a 60-month loan while the average 30-year fixed mortgage interest rate is about 3.99%.
To put this in perspective, if you took out a $10,000 personal loan to buy a car with a 20% interest rate and a five-year repayment term, you'd pay nearly $16,000 over the term of the loan. By contrast, if you took out an auto loan for the same amount with a five-year repayment term and a 4.21% interest rate, you'd only pay about $11,100 overall.
Vacations and weddings are fun, but they're not necessary expenses. Taking out a loan to cover these optional and already expensive events just isn't smart. You're better off saving for these occasions well in advance so you have enough money when the time comes.
Estimate how much you will need and when you’ll need the money by. Then, figure out how much you must save each month in order to make that happen. If you're unable to make ends meet, consider cutting your expenses, delaying the event, or looking for ways to increase your income, like starting a side hustle.
Chronically borrowing money is a sign that you're in serious financial trouble. A personal loan may help you in the short term by giving you some fast cash, but it could leave you with an even bigger problem over the long term as you'll have to pay back everything you borrowed, plus a hefty chunk in interest, too.
If you're considering a personal loan to help put food on the table or keep the lights on, it is time to seriously reevaluate your budget. Look for areas where you can cut costs, like dining out or cable, and try to boost your income by working overtime or pursuing a promotion. Consider applying for government benefits if you believe you qualify. You may even have to take more drastic steps like moving to a more affordable area where living costs are lower. It's not an ideal situation to be in, but making these moves is better than perpetuating your debt cycle.
When you apply for a personal loan, your lender should tell you how much your monthly payments will be. If you're unsure whether you can pay this much each month, you shouldn't take out the loan. The risk of default is high and extremely costly.
Your lender will report your missed payments to the credit bureaus and this will lower your credit score. You'll probably end up with debt collectors coming after you. And you won't be able to take out any new loans to because no lender will be willing to take the risk that you'll also default on your payments to them.
Borrowing money to invest isn't a good idea because there are no guarantees that you're going to make money. It's possible, but if you invest the money in the wrong assets, you could wind up losing the borrowed amount, which you'll then have to pay back out of your own pocket.
If you'd like to get into investing, start setting aside a little money each month to put toward this goal. With the rise of robo-advisors, you can get started with just a few dollars and you don't have to know that much about investing to make a profit. Or you could employ a financial advisor if you want more personalized investment advice.
Personal loans can be a great way to help you pay down high-interest credit card debt or make some upgrades to your home, but that doesn't mean they're the right answer in every situation. If any one of the five above scenarios apply to you, stay away from personal loans and try saving up on your own or taking out another kind of loan instead.
The Ascent team vetted the market to bring you a shortlist of the best personal loan providers. Whether you're looking to pay off debt faster by slashing your interest rate or needing some extra money to tackle a big purchase, these best-in-class picks can help you reach your financial goals. Click here to get the full rundown on The Ascent's top picks.
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