Should you ever take out a personal loan?
Personal loans are used for a variety of purposes. The most common reasons for taking out a personal loan include debt consolidation, medical bills, home improvement projects, large expenses such as weddings and vacations, and refinancing an existing loan.
When you need cash fast, a personal loan can look pretty tempting. We get it. A personal loan may seem like a really great option. But is it?
What is a personal loan?
A personal loan is a loan that’s borrowed for personal use, in contrast to a business, real estate, or student loan.
Personal loans can come from a bank, a credit union, an online lender, or even a friend or family member (are you sensing the risk already?).
Most importantly, personal loans are generally unsecured. Secured loans are backed up with some sort of collateral, such as your house or car. Unsecured loans, on the other hand, are not backed up by an asset. This means that the lender has nothing to fall back on in case you are unable to make your payments. Because unsecured loans are a much higher risk to the lender, these loans typically have a significantly higher interest rate. While personal loans generally carry a higher interest rate than secured loans, they often (but not always) have a lower rate than credit cards.
Should you take out a personal loan?
When considering whether or not you should take out a personal loan, here are some questions to ask yourself:
- What is the purpose of the loan?
- Is it the cheapest way to get the money?
- Is a secured loan an option?
- Can I afford to make the payments?
- Will the debt be productive? Will it allow me to generate a return greater than the interest rate?
Let’s dive a little bit deeper into these questions. A personal loan is a good idea only if the debt you take on from the loan will be productive. Will the loan allow you to generate a return in excess of the interest rate? If the debt allows you to generate a greater return than the interest, then it may make sense. However, if that’s not the case, the debt should be avoided. It will just generate a bigger problem to deal with in the future.
Should you use a personal loan to pay off other debt?
Many people decide to take out personal loans in order to consolidate other debt. If you have multiple credit cards or other areas of debt that you are paying off, this may seem like an appealing option. A personal loan might have a lower interest rate than some of your credit card debt. It may also feel easier to manage, since you could simply make one payment per month instead of multiple payments.
However, in our opinion, if you’re struggling with credit card debt, taking out another loan will probably not solve your problem — it will only shift it.
If you are struggling to pay of your credit card debts, here is what we recommend instead. Before trying to consolidate, first, establish a discipline of paying your existing debts. If you’re not consistent with paying your current debts, you’ll likely have a difficult time being consistent with paying a debt that has simply been moved. The last thing you would want is to consolidate using a personal loan and then have your credit card debt just build up once again. This would leave you with another problem of being responsible for both a personal loan AND more credit card debt. Be consistent about your current debts first. If you’re frustrated by having too many payments to manage each month, put your bills on autopay to be sure you don’t miss paying on time.
Be wary of personal loans
So, should you ever take out a personal loan? As you’ve likely gathered, we suggest only using a personal loan for a true need. In most cases, a personal loan will do you more harm than good. Don’t try to get too fancy in regards to finding the best interest rate or the best way to pay off your debts. These methods can be helpful, but what is most helpful is organizing your bills to pay off your current debts diligently. Don’t spend more than you make! If you’re struggling with credit card debt, this simple concept can be transformative for your finances.
Are you working with a financial planner for your wealth management and retirement planning? At Milestone Wealth Management, we exist to set you up for success in regards to your financial future. If you want to be certain you’re headed in the right direction in your financial planning, give us a call today.
This material is not intended to replace the advice of a qualified tax advisor, attorney, or accountant. Consultation with the appropriate professional should be done before any financial commitments regarding the issues related to the situations above are made.