You are perhaps used to the concept of using a loan to finance a big expense like buying a home, consolidating high-interest debt, or paying for college?
Many will even take a personal loan to finance a lifestyle expense, such as travelling to Dubai on vacation, getting a complete makeover like Botox or laser treatment. In theory, you can get an unsecured loan easily too because there is no collateral put up by you against the loan. An application is assessed on the basis of your income, assets and other debts. This makes them easier to arrange than a secured loan such as a mortgage.
Using the proceeds of a persona loan, you could go on a holiday, visit a laser clinic such as byoulaserclinic, remodel your home, or upgrade your car.
Many financial experts advise against taking a personal loan. So, when considering one, you should always compare savings and loans. Which will be better for you – finance from savings or take a loan?
What Is a personal loan and how does it work?
A personal loan is a credit offered to you for personal reasons unlike auto loans and mortgages, which are for specific purposes. Often, the lending agency won’t even ask the reason for the loan. However, all lenders will check your credit score before issuing or rejecting the loan. The lending business will also ask for your income documents to find out how much money you make every month.
You may still be approved if you have a lower score, but your interest rate will be higher. Often, those with a credit score below 610 will be rejected or the interest rate will be very high. Borrowers with a score of more than 800 get the best rates.
How do personal loans work?
This is a kind of instalment loan where you will get a lump sum of money that has to be repaid in fixed amounts every month until you have repaid the entire loan and the interest. The amount you get can vary between $1,000 and $50,000.
One key feature of a personal loan is that it is an unsecured loan, which means, there is no collateral. In a secured lawn, like a home loan, for example, your property will be seized if you don’t repay. The interest rate is higher than a car loan or mortgage because the lender is taking a bigger risk. The interest rate will vary for everyone. It depends on various factors like your credit score, debt-to-income ratio, and also on your previous loan repayment record.
There are some secured personal loans too that are offered against collateral, which could be your property, car, or bank account. The interest here is lower and the qualification criteria are also easier. However, you can lose the collateral if you cannot repay within the stipulated time.
Advantages and drawbacks of personal loans
There are both pros and cons of these types of loans.
- You can take it for anything – Very few lenders are going to ask why you need the money. It can be for anything, like a wedding, a holiday, to pay off a medical debt, remodeling your home, or urgent car repairs. Some lenders will however have some restrictions, like casino gambling, for example.
- No collateral – The lender will not ask for any collateral. This means, your home, car, or another asset won’t be taken away even if you cannot repay the loan. But there can be other consequences. Your credit score will also take a big hit.
- You can build credit history – These days, all loan and repayment records are reported to the major credit bureaus – TransUnion, Equifax, and Experian. Your credit score will improve when you take a loan and repay on time. But, if you don’t repay on time, then your score can also go down. Payment history makes up 35% of the FICO credit score.
- You can consolidate debt – You can take a personal loan to pay off credit card and get out of other debts. This means, you will then have one single loan to repay instead of several, which will make it easier to manage. Your overall interest payment will also go down. Some lenders will pay off the debt instead of sending you the money.
- High interest rate – The interest rate is high, especially for those who have poor credit. The repayment terms won’t be favorable. It can even be higher than credit card for them.
- High penalties and fees – The high feel and penalties for not paying back on time will drive up the borrowing cost. The fee may vary between 1% and 6% of the amount. It can either be subtracted from the amount given to you or added into the repayment amount.
- Can damage your credit score – Lenders report non-payments and repayments within time. So, if you fail to repay within time or default, then it is going to be reported. This will damage your credit score. It will then become difficult for you to get loan in the future in favorable terms.
Pros and cons of saving money
Saving money is important and so is investing. You won’t have to take a loan if you have enough funds saved in your bank. However, if you save too much, then you will miss out on many investment opportunities. All rates for investments are higher than what you will get from your savings account. You could have earned more than what you are doing. So you see, there are some drawbacks of savings as well.
On the other hand, the funds in your savings account will be liquid. You can get it whenever you want. It is best that you strike a balance between investments, savings, and loans. Make sure that you have enough liquid funds, but don’t forget to make investments as well. Sometimes, taking a loan can be the better option.
Loans and savings are both very important. Which one you prefer is a personal decision based on your financial priorities, budget, and needs. Decide carefully because either way, it can affect your future financial situation.