What Is the Benefit of Obtaining a Personal Loan?
Personal loans can add a lot of flexibility to your financial situation. Here’s why.
Contributing Writer at Tally
June 12, 2022
Personal loans represent around 1% of consumer debt in the U.S., with credit cards making up 6%. People use them for anything from home remodeling to vacations. But what is the benefit of obtaining a personal loan over the many other types of financing out there?
A large part of their appeal is flexibility, but taking on debt is always a serious consideration, so they’re not necessarily a good fit for everyone. In this article, we’ll explain what personal loans are and run through the pros and cons. By the end, you should have a better idea of whether it’s time to make your personal loan application or look elsewhere.
What is a personal loan?
There are two aspects of personal loans that differentiate them from other types of financing: what they’re used for and how you pay them back.
Tackling the first one, Experian defines a personal loan as “a form of credit that can help you make a big purchase or consolidate high-interest debts.” Borrowers might use personal loans for:
Large purchases (e.g., weddings or vacations)
Home improvement projects
This separates them from loans that you can only use for a specific purpose, like auto loans and student loans.
Then, we come to the second aspect: how you pay them back. Personal loans are installment loans, which means you borrow the principal loan amount upfront for a fixed loan term and repay it (plus interest) through monthly payments. Your lender defines the size of your monthly installments and how long you’ll need to make them in your terms and conditions.
In contrast, forms of revolving credit — like credit cards and lines of credit — allow you to continuously borrow up to a specified credit limit and repay the money.
Types of personal loans
Although all personal loans fit the description above, there are a few different types of personal loans with their own unique features. You may encounter secured or unsecured loans, and fixed- or variable-interest loans.
Secured personal loans require you to put down collateral (e.g., your house). This lowers the risk for the lender if you’re unable to repay your debt. Unsecured loans don’t require any collateral, which may mean lenders charge more interest.
Most personal loans have fixed interest rates, which means you’ll be paying the same interest rate for the loan’s entire duration. However, it’s also possible to get a variable-rate personal loan, which means the lender could change how much interest you pay (therefore changing the size of your payments).
So, what is the benefit of obtaining a personal loan?
Now that we’ve covered the basics, let’s look at the five biggest benefits of a personal loan over other borrowing methods.
The ability to borrow funds with few stipulations is perhaps the biggest benefit of using a personal loan. Lenders give you the funds in a lump sum, and then you’re free to use them as you wish (as long as you meet your repayment obligations). The agreed-upon amount of money is often deposited straight into your bank account, so you can use it immediately.
In contrast, most other loan types require you to specify what you need the money for and don’t allow you to spend it on anything else. For instance, you wouldn’t be able to take out an auto loan and use it to pay for a college education.
Plus, many lenders of personal loans will allow you to choose repayment terms that suit you. Maybe you’d prefer a longer loan term so your monthly payments are lower or a shorter loan term to minimize interest payments.
You might be thinking that credit cards are also a flexible type of loan, and that’s partly true — which is where our next major perk comes into play.
2. High borrowing limits
Personal loans let you borrow large sums. The average new personal loan has a balance of $6,092, and you may get an even higher loan if you have a good credit score.
This makes them a great option for major purchases and emergency expenses like medical bills or vehicle repairs. You could even use your loan to refinance existing higher-interest debt.
Credit cards might be flexible, but they often have lower limits. This is fine if you just want to use them for smaller unexpected expenses, like a new tire for your car, but your credit card account likely won’t be able to cover bigger costs.
Even if you’re lucky enough to have a high credit limit, most experts recommend keeping your credit utilization ratio (the percentage of your available credit limit you use each month) below 30%. This means a personal loan could be the better option for keeping your ratio low and preserving your credit score.
3. Lower interest rates than credit cards
In general, personal loans have a lower annual percentage rate (APR) than credit cards. The average interest rate for credit cards in the U.S. is 16.45%, while the average APR for a personal loan ranges between 10% and 13%. If you have excellent credit, you may be able to secure an even lower rate.
A lower APR means you’ll have lower monthly payments and pay less over the course of the loan. For instance, if you took out a $10,000 personal loan with an APR of 10% and a loan term of three years, you’d pay $322.67 each month. But if that APR was 16% and nothing else changed, monthly payments would rise to $351.57. That extra $28.90 per month adds up to over $1,000 in the course of three years.
Plus, if you use a higher-interest credit card instead of a lower-interest personal loan, you may have to pay compounding interest (meaning you’ll have to pay interest on your interest). If you fail to make your monthly payments on your card or don’t pay your balance in full, your interest will continue to compound, making your loan balance grow higher and higher. This is another reason why personal loans are one of the better options out there.
4. Reliable repayment schedules
Since personal loans require you to specify how much you’re borrowing and for how long (and most of them have fixed interest rates), you’ll know your repayment schedule from the get-go. You can expect to pay the same amount each month, as long as you make the payments on time and are not charged penalties.
This makes it much easier to track and manage your debt and plan for the future because you know exactly how much you’ll need to pay each month and can budget for that.
5. Opportunities to build credit history
Personal loans are a good option if you’re looking to build your credit history and credit score. Once you start making on-time payments toward your personal loan, your lender will likely send this information to credit bureaus, and it may boost your score over time.
Why? Because you’re showing that you’re responsible with money and can be trusted with borrowed funds. Making loan payments on time can also help you secure better interest rates on future loans or lines of credit — and you never know when you might need these.
What are the disadvantages of personal loans?
Personal loans have their perks, as we’ve seen. Yet there are some disadvantages that are worth considering.
Limitations on eligibility
You’ll only be able to take out a personal loan if you can get approved in the first place, and this is not guaranteed. Lenders will look at your credit history to determine your creditworthiness, and those with bad credit (a score below 670) may struggle to get approved.
If you’re unsure about your eligibility, most lenders carry a pre-approval process, which involves a soft inquiry that doesn’t harm your credit score but tells you if you’d get approved.
Even if you’re not eligible for the best personal loans on the market, you may still be able to take one out with a poor credit specialist or credit union.
As we’ve already mentioned, it’s important to make your loan payments on time. If not, your credit score may drop, and you may be charged penalties, increasing the amount of money you owe the lender. This is something to consider when taking out a personal loan.
You may also have to pay origination fees, which are a fixed cost to open the loan, and they tend to range between 1% and 5%.
Additionally, you could face prepayment penalties if you attempt to repay the loan too early. This fee ensures the lender can collect the interest on your loan they were expecting. Therefore, if you expect to repay your loan early, a line of credit or credit card may be a better fit since they don’t carry this type of penalty.
Lower interest rates elsewhere
Although we’ve said that personal loans have lower interest rates than credit cards, they don’t necessarily have the lowest rates of all loans on the market.
Home equity lines of credit (HELOCs) are a type of secured loan in which you put up the equity in your home as collateral. Because your lender can seize your property if you fail to make payments, they tend to offer very low rates. The average APR is 5.14% for a 20-year HELOC.
However, keep in mind, since HELOCs are secured, you do run the risk of losing your home if you fail to repay the loan.
Make the right choice for you
There are plenty of loan types and choices in the market, but there are a few benefits to opting for and obtaining a personal loan. They’re flexible, carry lower interest rates than credit cards yet boast higher borrowing limits, and allow you to improve your credit history. However, there are disadvantages that might mean a personal loan isn’t the right fit for you.
If you’re considering a personal loan as a way of refinancing your credit card debt, look into the Tally† app instead. It automatically pays down high-interest debts on your credit card with a lower-interest line of credit.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.