Personal loans are excellent products when you need cash instantly but sometimes it isn’t the best choice.
By Guy Avtalyon
You don’t think that such a situation is possible when personal loans are bad? Well, they can be. It is an old wisdom that banks approve loans only to people who do not need them. It is wisdom older than money-lending is as a business and a very wrong one. Banks approve loans only to people and companies they judge to be able to return them. But every person should also judge the fact that if you are able to return a loan doesn’t necessarily mean you should get one.
What Are Personal Loans?
In short, a personal loan is an installment loan that is not with a specific purpose. They are almost always unsecured, which means that when you take it you do not use some collateral against it. In other words, you do not guarantee with some property or belonging that it will be returned in full. Their term usually runs between 12 and 84 months, depending on the lender, and can usually be worth between $1,500 and $100,000. As with all other forms of borrowing, there is some annualized interest rate you need to pay on top of the borrowed amount. How much it is, depends mostly on the lender’s judgment of your creditworthiness. In other words, the lender’s opinion how likely you are to return it in full. If the lender sees you as very likely to pay it back you will get offered very low interest-rates and vice versa.
What Are Personal Loans For?
Personal loans are most often used in cases of unplanned need for cash and for debt consolidation. In life, things happen, and people find themself in a financial emergency. In a situation when you need cash injection very quickly they can be an excellent solution. Also, over the years the interest of various credit cards and credit lines can accumulate, and you can stumble upon a personal loan offer with much smaller interest rates. So, it may be a prudent move to consolidate all of your debts into one, and also decrease both your monthly payment rate and annual interest rate.
When Personal Loans Are Bad?
Personal loans are very versatile and can come very handy in some situations. But in some situations, they can be a bad solution, or even create more problems for you. So, here is when personal loans are bad for everyone.
Spending on wants instead of needs
Maslow’s Theory of Human Motivation concludes that, for good mental health, a person first must satisfy needs and then wants. For your personal financial health, the same principle applies. Spending money on vacations, gadgets, and other unessential things while you have other essential things to worry about is not a smart thing to do. Taking a personal loan for such wants even doubly so. Pampering to oneself is good for any person, but it must not be done at the expense. And a piece of sound advice for borrowing is that the debt for something should never outlive that very thing.
They are unfavorable
Another situation when personal loans are bad.
Because personal loans are usually unsecured, they can come with some financial drawbacks. First, and the most obvious, one is the high interest. Generally speaking, it can range from 5% to 35% per year, depending on the lender and your personal creditworthiness. Thus it is very important that you shop for the best possible rates, but also take into consideration some other financing offers, such as home equity credit lines, that could be more affordable for you.
Many lenders do charge so-called “prepayment penalties”. It’s a fee you can be charged for paying off your loan earlier. And if you feel confident that at some point in the future you might be able and willing to pay it off, you must be careful to take into account this potential fee. Especially if you are comparing various offers. And to be aware that the higher the loaned amount, the higher this fee can be. And sometimes it can be a considerable amount.
Some lenders also charge a so-called “origination fee”, which can be between 1% and 6%. It is often either calculated into monthly payments or take out of the loan amount. But either way, it increases your expenses of borrowing. And for short term loans, it can be a substantial increase compared to some other options.
Fixed monthly payments and term do not suit you
For various people, for various reasons, fixed monthly payments can be unfavorable. If you have incomes that vary from month to month, or you are used to monthly minimum fees, the fixed monthly rate might be a financial pitfall of a sort for you. If you miss a payment or two, the lender could sue you for the outstanding debt. That could bring considerable financial hardship. The main characteristic of personal loans is the fixed monthly rate, and you must keep this in mind when shopping for borrowing options. If you are not 100% certain that through the whole term of the loan you can pay that amount, it might not be the best option for you.
Also, the term of the loan is fixed. And this inflexibility can be a hurdle if you unexpectedly find yourself in a bit of financial hardship. You will not be able to decrease the monthly rate by extending the term of the loan. This is exactly the situation when personal loans are bad for you.
Personal loans should never be used for investments. Borrowing money is not a sound idea, because no investment is a sure thing. No matter how safe investment might seem, things can go south in a blink of an eye. And any investment is exposing yourself to financial losses. Borrowing for such is just a doubling of financial risk. You should always invest only money you can afford to lose.
You are not disciplined
Personal loans are often used for consolidating existing debts. Various credit card loans and balances can seemingly be wiped off with a single personal loan. But they don’t actually disappear. They are still there but in the form of a single consolidated monthly payment. And if you are unable to prevent yourself from again racking up unsustainable credit card balances, it might be a more sound decision to continue to limp along the way. But first and foremost, you should be honest with yourself. If the credit card is burning a hole in your pocket, you should think carefully about what is better for you in the long run, before your debts spiral out of control.
Personal loans are an excellent option when you need cash and need it quickly. But in some situations, they are not the best option available for you or your needs. There could be some more affordable options and even some which give you more flexibility to cover your needs.