Benefits and Drawbacks of Obtaining a Personal Loan
6 min read
Updated on August 1, 2023
Whether you need extra cash for a major purchase, an emergency expense, or a home improvement project, a personal loan might be a beneficial option for you. But when it comes to making any financial decision, it’s important to explore the benefits and drawbacks (i.e. pros and cons) first.
So if you’re wondering if a personal loan might make sense in your financial future – you’ve come to the right place. In this article, we’ll discuss what a personal loan is, as well as the potential benefits and drawbacks of obtaining one.
What Is a Personal Loan?
A personal loan is a lump sum of cash given to a borrower by a financial institution (like credit unions, banks, or online lenders) for — you guessed it — personal use. You are required to pay the loan back in monthly installments over the loan term (aka how long you have to pay it back).
Personal loans can be used for a wide variety of reasons, from paying off credit cards to home improvement projects. But keep in mind, some lenders have specific restrictions on what you can use the loan for. For instance, many lenders don’t offer loans to be used for student loans, down payments on a house, or business expenses.
According to Experian, the average personal loan balance in 2022 was $18,255. However, your loan amount eligibility is based on several factors which are evaluated during the loan application process. Namely, your credit history and credit score.
Now that you know what a personal loan is, let’s talk about some potential benefits of obtaining one.
What Are Potential Benefits of Obtaining a Personal Loan?
We’re glad you asked! Certain purchases could be beneficial when made with a personal loan as opposed to using your current finances (i.e. your savings or credit cards). This, of course, depends on your financial situation and current credit report.
Some potential benefits of obtaining a personal loan include:
- Consolidating your high-interest debt
- Building your credit score
- Financing large purchases
- Funding emergency expenses
A personal loan may even help improve your financial situation in certain instances — for example, on-time loan payments could boost your credit score by the time you pay the loan off (we’ll explain this more later).
But, be prepared to make your payments on time each month, so you avoid damaging your credit score.
Consolidate Your High-Interest Debt
High-interest debt. It’s not a fun topic to discuss, let alone deal with.
One common type of personal loan is referred to as a debt consolidation loan. It’s when you pay off high-interest debt, like credit cards, using your lump sum of loan cash – all in one fell swoop!
What’s the benefit of debt consolidation? For starters, it could simplify your debt management. For example, instead of making multiple payments to different creditors, you would make a single monthly payment towards your personal loan. Easy peasy.
Plus, if you could obtain a personal loan with a lower interest rate or a longer repayment term, you could lower your monthly payment amount. This could potentially save you money overall (that’s more money in your pocket every month).
Build Your Credit Score
Ah, credit scores. They’re like a recommendation letter (in the form of a number) that explains to lenders if you’re trustworthy and reliable when it comes to repaying your debts. And who doesn’t want a good recommendation?
Your credit score is used to evaluate what loans and interest rates you qualify for during the application process. It’s determined by your credit report, which includes information about your credit history such as:
- Age & mix of your open accounts
- Number of your hard credit inquiries
- Your payment history
If you take out a personal loan and make your monthly payments on time according to your loan terms, you could boost your credit score. That’s because every on-time payment you make demonstrates your reliability. Plus, it could add a new type of debt to your credit mix, which lenders often like to see when evaluating your eligibility.
Remember that consistency is key! When you responsibly manage your debt (like a personal loan) and maintain a healthy credit history, your credit score could improve over time. This could help your chances of approval for future credit or loan applications.
Tip: You can get free credit reports every 12 months from the major credit bureaus (Transunion, Equifax, and Experian). Be sure to monitor your credit reports periodically and ensure they’re accurate and complete! There are also free credit score monitoring tools, like Credit Karma’s, that monitor and notify you of key changes or discrepancies in your credit report.
Finance Large Purchases
Your savings are for the future, like retirement or unexpected emergencies. Therefore, using your future savings to make a large purchase in the present doesn’t always make sense.
For instance, if you’re considering taking that bucket list vacation, or need to finance your wedding – these could be reasons you might consider obtaining a personal loan instead of dipping into your savings. In fact, some lenders allow personal loans to be used for those exact reasons!
Sure, you might pay a bit more in the long run (even if you avoid high-interest rates), but you could avoid the stress of coming up with the money you need in a short period of time. It’s one potential option to finance a large expense without breaking the bank – or pulling out that credit card.
Fund Emergency Expenses
If you struggle with building an emergency fund, you’re not alone. According to a recent study, more than half of Americans have $5,000 or less available in savings. And when you get unexpected expenses like medical bills or home repairs, finding the money quickly can be stressful.
You could use a personal loan to fund emergency expenses to avoid completely draining your bank account. This is one option if you find yourself needing funds in the event of an emergency, but it should be considered carefully. After all, you are still required to make monthly payments for your personal loan regardless of what you obtain one for.
What Are Potential Drawbacks of Obtaining a Personal Loan?
None of the potential benefits noted above mean that personal loans are perfect. Nothing in life is, right? This leads us to discuss the flip side – the potential drawbacks of obtaining a personal loan.
Some potential drawbacks include:
- Total Interest Charges: Your loan accrues interest from the time you take it out until you pay it off. You could end up spending more money on the initial loan amount after interest charges are added to the total.
- Additional Fees: Many loan offers include upfront fees, like an origination fee. And depending on your lender, you may face prepayment penalties if you pay off the loan too quickly.
- Credit Score Damage: As noted above, if you are not making your monthly payments on time, a personal loan could hurt your credit score.
Remember, your financial situation is unique to YOU. Be sure to carefully consider how these potential drawbacks might impact your finances before you decide to apply for a personal loan.
Frequently Asked Questions About Personal Loans
Before we conclude, let’s go over a few commonly asked questions about personal loans, shall we?
How is a personal loan different from a credit card?
A big difference between personal loans and credit cards is in their monthly payment amounts.
A personal loan has the same monthly payment amount because it’s based on the total amount of your loan (until it’s paid off... then your monthly payments are done!). Alternatively, credit card payment amounts depend on the card balance, which is often inconsistent every month.
Additionally, personal loans often have a lower interest rate than credit cards. But as we covered earlier, the approved interest rate will be determined by a borrower's overall credit history.
What is the difference between a secured and unsecured personal loan?
In short, secured loans require collateral and unsecured loans do not. Collateral is a valuable asset owned by the borrower (like a car or home) that serves as a promise to a lender that the funds borrowed will be repaid. If it isn’t, the collateral can be seized by the lender in order to get their money back.
While an unsecured loan does not require collateral, it often has a higher interest rate, which is important to consider when exploring your personal loan options.
Can you get a personal loan with bad credit?
You may be able to get a personal loan if you have bad or poor credit, but the loan amount will depend on the lender you choose and their specific lending requirements.
Usually, a higher score makes it easier to qualify for a loan and may result in a better interest rate. Most credit scores range from 300-850, according to Debt.org. Someone with good credit or excellent credit may be offered lower rates on personal loans and potentially a higher loan amount, whereas someone with little to no credit or poor credit scores might be offered a lower loan amount at a higher interest rate.
If your credit doesn’t allow you to obtain a personal loan, you could ask a trusted friend or family member to be your cosigner. This could be an option for you, but keep in mind that not all lenders offer it.
Got more questions about personal loans?
We’ve got more answers. Check out our FAQ page to learn more!
Explore Your Options through Splash
Interested in what personal loan offers you might qualify for? Check your rate through Splash with no impact on your credit score!1 Simply answer a series of questions about yourself and your loan request, then browse the offers you qualify for across our network of trusted lenders.
The information provided in this blog post is not intended to provide legal, financial or tax advice. We recommend consulting with a financial adviser before making a major financial decision.