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We all come to our financial independence (FI) journey from different places. Some people may be lucky enough to start their FI journey early and with little to no debt. For others, it’s a different story.
Debt can feel like a huge hurdle to clear at the beginning. But you may be able to find help in an unlikely place: with a personal loan. We give you the rundown on how personal loans work, when to use them, and when to avoid them.
How do personal loans work?
If you need to borrow money for personal reasons outside of borrowing to buy a home, a car, or attend school, a personal loan is an option. Personal loans allow you to borrow a fixed amount of money and repay it over a set period of time.
Most personal loans are unsecured loans, meaning there is no asset being used as collateral. This is different for a secured loan, like a mortgage, that would use your home as collateral against the loan.
If you stop paying your mortgage, the lender can foreclose on your home (the collateral). With an unsecured loan, the lender can’t foreclose on a piece of collateral to get their money back if you stop making payments.
Because personal loans are unsecured, a lender looks at them as being riskier. That means a lender will look closely at your credit score and income, to ensure you have the ability to repay the loan. They also tend to charge higher interest rates than secured loans, to make up for the additional risk.
Personal loans can be used for a wide variety of things including:
- Adoption costs
- Medical bills
- Home improvement loan
- Moving costs
- Debt consolidation
Can a personal loan be used for debt consolidation?
If you’re on your path to FI, we don’t recommend taking out a personal loan to pay for a vacation or a wedding. But debt consolidation? It might help.
If you’re struggling with credit card or other high-interest debt, a personal loan can offer help. Here’s how: credit cards can come with extremely high-interest rates. These interest rates can make it extremely difficult to pay down your debt because you spend so much money each month paying the interest.
Instead of sticking with high-interest credit card debt, you can borrow money with a personal loan. These loans usually have lower interest rates than you’ll find with a credit card. You then use the personal loan to pay off your credit card debt and start making payments on the personal loan.
And this the savings can be significant. For example, say you have $15,000 in credit card debt between two cards. The average interest rate that you pay on this credit card debt is 17%. You make total monthly payments of $300. With this plan, it’ll take you 7.3 years to pay off your debt and you’ll pay $11,277 in interest. Ouch.
But if you take out a personal loan to pay off that credit card debt, your payment timeline changes. Say you take out a personal loan for $15,000 with a 7% interest rate and a five-year loan term. Your monthly payment will be $297 and over five years, you’ll pay $2,821 in interest — a significant saving.
Yes, you’re swapping one debt with another, but the goal is to lower your interest rate, pay off your debt faster, and keep you moving on your path to FI.
Want to try out your own calculation? We built a compound interest calculator that’s simple to use so you run through any scenario you want, easily.
Is taking out a personal loan a good idea?
Whether a personal loan is right for you, depends on how you plan to use it.
When you should use a personal loan:
You may think that all debt on your path to FI is bad debt, but there are some times when a personal loan isn’t such a bad idea.
- Consolidate high-interest debt: Like the example above shows, if you have high-interest debt, like credit card debt, consolidating it with a personal loan that has a lower interest rate and fixed payments can help you pay it off faster. But one word of caution: if you use a personal loan to pay off your credit card debt and don’t change your spending habits, you’ll find yourself right back to being overwhelmed with credit card debt.
- Certain home improvements: House hacking is a powerful tool many people use on their path to FI. If you own a home with the potential to house hack (for example, by finishing a basement), but you need the money to make the improvements, a personal loan can help. Hopefully, once your house hack is complete, you can use the extra rent you collect to pay off your personal loan quickly.
When you shouldn’t use a personal loan:
For people with good credit and steady income, accessing a personal loan can be fast and easy. But that doesn’t mean borrowing is a good idea. Here are some situations where you won’t want to use a personal loan.
- Unchecked spending: We can all use a little cash from time to time, but a personal loan for discretionary spending won’t get you closer to FI. Instead, it’ll just keep you stuck in a cycle of debt. Wedding, vacation, or boat purchase? Skip the personal loan.
- Medical costs: Medical expenses can get overwhelming quickly. But before you apply for a personal loan, ask your medical provider what payment plan they can arrange for you. You may find that the terms they offer are much better than what you can get with a personal loan.
What to watch out for with personal loans
Personal loans are not all created equal. There are a number of things you’ll want to look for when deciding whether a personal loan is a good option.
- Interest rate: A lender will determine your interest rate based on your credit history and income (along with other factors). Interest rates on personal loans can vary widely, with some personal loan interest rates reaching over 30%!
- Fees: Some lenders charge different fees, like an origination fee or a prepayment fee. Factor the cost of the fees into the total cost of the personal loan to make sure it’s still a good deal.
- Loan term length: Loan terms on personal loans can range, but you’ll find that most of them are between 12 and 60 months. With a longer loan term, you’ll be able to lower your monthly payment but you’ll pay more in total interest.
How to get a personal loan
Getting a personal loan is a relatively quick and simple process, but there are a few steps involved. Follow this plan to start your personal loan search:
Check your credit history
Before applying for a personal loan — or any loan — it’s a good idea to check your credit history. Because lenders will rely on your credit history to determine if you’re a trustworthy borrower, you’ll want to make sure it’s accurate.
You can pull your credit history for free using a service like AnnualCreditReport.com. Review it for any errors and make sure it correctly reflects your true credit history.
Search for lenders
There are a lot of lenders that offer personal loans. Depending on your situation, you may want to explore different types of lenders. Here’s what you can expect to find from each type of lender:
- Local Credit Unions: If you have bad credit, a local credit union may be able to help. Credit unions are not-for-profit organizations that are owned by their members. They are sometimes more flexible with who they will offer personal loans to so someone with bad credit may find favorable rates working with a local credit union.
- Federal Credit Unions: Another option for borrowers with bad credit is a Payday Alternative Loan (PAL) from a Federal Credit Union. Payday loans are made by predatory lenders that keep you in a cycle of high-interest debt. A PAL from a federal credit union offers borrowers small personal loans.
- Banks: Most banks also offer personal loans, though they tend to have strict qualification requirements. Depending on the bank, you can usually apply for a loan online or in-person.
- Online lenders: These lenders offer a streamlined experience and quick approval for personal loans. With some lenders, you may be able to get your funds in as little as a day. To get the best rates with an online lender, a borrower must have a strong credit score and income.
Make a list of lenders you’d like to research and move onto the next step.
Compare rates and fees
Because there is such a wide range of rates that lenders will offer, it’s a good idea to check the rate and loan terms with multiple lenders. Getting the lowest interest rate possible can help you pay off the loan without overpaying in interest.
If you plan to check rates with online lenders — and you should — there’s no need to check rates with each lender individually. That’s not only time consuming but it can be a little intimidating to pick out an online lender you can trust.
Our favorite tool for comparing rates is Credible. Instead of filling out multiple applications with different lenders, Credible allows you to compare rates from lenders while just filling out one application. Simple, easy, and can save you thousands by finding you the best deal. Plus, it’s free, and using Credible won’t affect your credit score.
While Credible won’t be able to help you check rates with local banks and credit unions, it makes the process for researching online lenders very simple.
Re-work your monthly budget
Because loan payments start shortly after your loan is funded, it’s important to re-work your monthly budget to accommodate your new debt payment. Before you finalize your personal loan, create a budget that includes your loan payments and make sure it’s realistic.
Choose a lender and get your money
Once you’ve compared rates and ensured the loan payments will fit into your budget, it’s time to pick the lender who offers you the best options. If you started the loan application process with Credible, you’ll finish it with your selected lender. They’ll ask you to submit loan verification documents, like your pay stub or W-2.
As soon as you have final approval from the lender, you’ll receive your money, sometimes in as little as a day.
One last word on personal loans
While you may not think of a personal loan as very FI, we’re all starting our journey from different places. When used correctly, a personal loan can help you crush your high-interest debt and shorten your path to FI.
But not every personal loan is created equal. Do your homework to find the best personal loan. And once you’ve done that, look at changing the habits that saddled you with the high-interest debt in the first place.