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Blog » Personal Finance » When Should You Take Out a Personal Loan?

When Should You Take Out a Personal Loan?

Posted on August 23rd, 2023
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A personal loan is a lump sum of money you can borrow from a financial institution and slowly repay with regular monthly payments plus interest. Most banks, credit unions, and online lenders offer different personal loans that can be used for almost anything. People use personal loans to pay for overdue hospital bills, emergency repairs after an accident, and happier occasions like extravagant vacations or home renovations. 

But there are certain things you usually can’t take out personal loans for and certain things that may disqualify you. In this article, we’ll attempt to answer the question, when should you take out a personal loan? Spoiler: the answer will depend on you and your finances, but there are general things everyone should know before applying for one of these types of loans. 

Key Takeaways

  • You can take out a personal loan for almost any reason, but loan consolidation is one of the most popular. Loan consolidation is most financially beneficial when your new APR is lower than the APR you were paying on existing debt. 
  • Having bad credit may disqualify you from taking out a personal loan, but you may be able to obtain one without exorbitant interest rates if you have a co-signer or agree to a secured loan. 
  • Check to make sure you can afford the monthly payment and any credit check and origination fees. Don’t agree to a loan you won’t be able to pay back each month. 

What is a Personal Loan? 

A personal loan is a lump sum of money you receive from a financial institution and agree to pay back in monthly chunks with interest. Most personal loans are unsecured, meaning you don’t have to add collateral to your loan agreement. A secured loan, like a mortgage or auto loan, comes with collateral the lender can take if you don’t make payments. 

Some of the most common reasons people take out personal loans include paying for medical debt, car repairs, home renovations, dream vacations, unexpected accidents, and weddings. A personal loan is usually very flexible with what it can be spent on, though there are exceptions. 

Many lenders will not allow you to use a personal loan on business expenses. Similarly, some lenders won’t allow you to spend your loan on college tuition. This is because the U.S. government has certain requirements for lenders loaning money to people for those purposes, and some lenders prefer to circumvent those restrictions. 

You are usually also precluded from using a personal loan on a down payment for a house. This is because of lending requirements set by the FHA and conventional mortgage lenders. For most other purposes, though, a personal loan can be a tool to get that extra bit of financing you need to afford something. 

What Should I Do Before Applying for a Personal Loan? 

The two things you should absolutely do before applying for a personal loan are check your credit report and check your finances. Lenders will run a credit check and gauge your debt-to-income ratio before offering you a loan. If you’ve had an unstable employment history or bad credit, there’s a possibility you’ll be rejected for a personal loan. 

It’s therefore important to check your credit and dispute anything you think is inaccurate. After that, check to make sure you can actually afford to take out a loan. Understanding the repayment schedule is important before agreeing to a loan. Also, factor in any origination fees and credit check fees the lender may charge. 

As you research and prepare to inquire into different personal loans, remember that when lenders run hard inquiries into your credit history, it can ding your credit score. However, if you do your rate shopping within a 45-day period, multiple credit inquiries will be grouped together as a single inquiry and only impact your score once. 

The Steps to Applying for a Personal Loan

Let’s break down the steps for applying for a personal loan, from initial planning to actually receiving the money. 

Research 

Once you’ve determined that you need a loan, start researching different online lenders, credit unions, and traditional banks to see what kind of loan you could get. Try to identify the following things when assessing an offer: fees, interest rates, collateral requirements, and spending requirements (can you use the money for business expenses, for example).

Don’t be afraid to reject some options. You should have more than one option, especially if you have fair or good credit. 

If you’ve had an account open at one bank for a significant amount of time, consider going to them first to inquire about personal loans. They may offer you better rates if you have a good spending history with them. 

Applying/Assembling Documents 

Now that you’ve selected a loan option you’d like, you’ll need to apply. The application process will be different for every lender and may require you to go in person to a bank branch or credit union. You’ll need to provide documentation showing proof of income, place of residence, and legal ID. You’ll also need to explain what you intend to use the loan for. Once you’ve given your lender everything they request, they’ll consider your application and choose to approve or reject you. At that point, you can consider their offer and the loan terms and then (if you choose) finalize your paperwork. 

Receiving the Funds 

Once you’ve done the final paperwork, you can expect to receive your funds within five to seven business days. Sometimes a lending institution can give you same-day funds, though it’s not guaranteed everywhere. 

Paying Back A Personal Loan 

You should expect to make regular, monthly payments to your lender with interest after taking out a personal loan. Interest rates for personal loans can vary widely. Some lenders will make loans with interest rates as low as 6%, while others can go above 30%. It will largely depend on your creditworthiness and debt profile. 

If you’re someone with bad credit who’s interested in taking out a personal loan but aren’t in a rush, it might be worth delaying taking out your loan and trying to build up your credit instead. Having good credit will allow you to earn a better interest rate and can keep you from needing a co-signer or collateral as part of your loan agreement.    

Who Should Take Out Personal Loan? 

Any adult can take out a personal loan, but of course, it’s better to never have to take out loans. Interest can be expensive in the long run, so avoiding it altogether is often a smart financial move. However, it’s also true that not all debt is bad debt. Paying off a mortgage, for example, requires you to go through a set number of years in debt, but it’s an investment that can turn quite profitable for you down the road. 

When it comes to gauging whether you should take out a personal loan, consider how important the thing you want to purchase is to you. Are you trying to fund a vacation you’ve been wanting to take for years but haven’t had the money for? While that may not be as essential a reason to take out a personal loan as, say, paying off medical debt, it may be important enough to you to take the risk.

If you’re young and unsure how you should divide your paycheck, consider the 50/30/20 rule, which suggests you should spend 50% of your paycheck on essential purchases, 30% on wants, and 20% on savings. Sometimes a lack of finances can be solved by better budgeting and money management before turning to loans. 

FAQs

What is loan consolidation? 

Some people take out personal loans to consolidate debt. This involves paying off existing debts using money borrowed from a different lender, who is hopefully giving you a lower APR than your existing debt. By consolidating debt, you can save money over time by paying less in interest to lenders. 

Do I need collateral to get a personal loan? 

No. Most personal loans are unsecured and therefore do not require collateral. If you have bad credit, though, looking for a personal loan that is secured may be an opportunity for you to secure a more competitive interest rate. 

How quickly will funds to distributed once I’ve been approved? 

Once you’ve completed your final paperwork, you should receive your funds within a week, though you should talk to your specific lender to better understand the timeline. 

What can I not use a personal loan for? 

Some lenders don’t allow you to spend money from a personal loan on education, a down payment on a house, or business expenses. Look at your specific loan terms and speak to your lender to make sure you’ll be using the money you’re lent in an acceptable way. 

The Bottom Line 

Personal loans can be used for many different things, but you should only take one out if you’re confident you can pay the required monthly amount and any associated fees. Having good credit will typically give you a better interest rate on your personal loan. Be sure to shop around for different rates before deciding on a loan to take out. 

Eric Rosenberg

Eric Rosenberg

Eric Rosenberg is a personal finance expert. He received an MBA in Finance from the University of Denver in 2010. Since graduating he has been blogging about financial tips and tricks to help people understand money better. He is a debt master, insurance expert and currently writes for most of the top financial publications on the planet.

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