Best and worst ways to use a personal loan

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The short answer to "Can I use a personal loan for anything?" is yes. A number of traditional and online options are available for taking out a personal loan, and if you have decent credit, securing this kind of loan can be a fast and easy process. But just because you can take out a personal loan doesn't mean you should. Consider the pros, cons and important factors of personal loans before filling out a loan application.

Good and bad uses for a personal loan

What you use a personal loan for is usually completely up to you, unless the lender has specified parameters for how the loan can be spent. With that in mind, you should also know that a personal loan is a financial tool that should be used responsibly, with caution, and for good reasons.

Good uses for a personal loan

A personal loan can be useful in your financial strategy if you use it responsibly. A number of good reasons exist for taking out a personal loan, including:

  • Education expenses
  • Purchasing or renovating a home
  • Debt consolidation

Most financial experts suggest that taking out a loan for an appreciating asset is a good use of debt. For example, a student loan that will increase your future earning power or a mortgage loan that allows you to own a home are good reasons for taking out a personal loan.

A personal loan can also be an effective alternative to high-interest credit cards. Many consumers charge their purchases with a credit card and treat that charge as a loan, carrying over their balances from month to month. If you've already amassed a large amount of high-interest debt, taking out a debt consolidation personal loan might be a good idea.

A debt consolidation loan bundles your existing debts into one package that allows you to make one monthly payment instead of many. If you can get a lower interest rate on the debt consolidation loan, the loan might enable you to pay off your debt more quickly. For example, if you have credit card balances with an average 20% APR, you could take out a no-fee debt consolidation loan with an average interest rate of 13% APR. By doing this, you'll save 7% APR in interest charges.

Bad uses for a personal loan

Although you can borrow money to use in whatever way you want, you should exercise caution when using a personal loan. Some poor uses of a personal loan include:

  • Vacations
  • Consumer goods
  • Lavish wedding

A personal loan shouldn't be used to increase your spending on unnecessary expenses. Consider the fact that a vacation, wedding and material goods last for a short period of time; but if you don't pay it off quickly, the debt can last for years. By taking out a personal loan for consumable debt, you're sacrificing the opportunity to build up your savings or retirement investing—and hurting your own financial future.

Depending on your financial habits, a personal loan could be a crutch for someone who has a problem with excess spending. Some individuals might continue to add to their debt as they reduce their total loan payments. If you're susceptible to this tendency, you're better off just paying off your existing debt as quickly as possible.

What to consider when taking out a personal loan

Most personal loans are unsecured or signature loans, which don't require a security deposit or collateral. Because of this lack of collateral, the risk is greater for the lender. Thus, interest rates on unsecured or signature loans are usually higher than those on secured loans. Also, the lower your credit score, the higher interest rate you'll pay, because a lower credit score indicates you are a risk as a borrower.

When considering the option of a personal loan, figure out your debt-to-income ratio. For example, if you make $4,000 per month and owe $1,000 in monthly debt payments, your debt to income ratio is $1,000/$4,000, which is 25%. Although there's no such thing as a perfect debt-to-income ratio, a lower ratio is better than a higher one: If your debt payments are too high, after making your payments, you won't have enough cash to meet your day-to-day expenses.

You should consider the details of the various personal loans available to you. Consider whether the personal loan is secured or unsecured, as well as the following factors:

  • Interest rates: Interest rates are additional payments—on top of the amount borrowed—that you owe the lender for the privilege of borrowing. A personal loan with a lower interest rate and a shorter term will help keep down your total repayment amount. If you choose to take out a personal loan, choose a lender offering the lowest interest rate. The better your credit score, the lower your personal loan interest rates will be.
  • Fees: Some lenders offer no-fee loans, which means there's no origination or other borrowing fee. The only liability you'll encounter is the repayment of the sum borrowed and the interest payments. Watch out for personal loan companies that charges high fees.
  • Terms: In general, it's preferable to take out a shorter-term personal loan than a longer-term loan. With a shorter-term loan, you'll end up paying less in total interest charges.
  • Lender: Vet the lender for your personal loan. Understand the loan fees and credit score required by the specific lender. Read reviews to ensure that you're choosing a reputable firm.

Alternatives to a personal loan

Before committing to a personal loan, you should consider alternative sources of capital. Here are a few suggestions for other sources of funds:

  • Low- or no-interest credit cards: Make sure to read the fine print to avoid accruing additional debt and interest payments. Also, it's wise to pay off the charges as quickly as possible to minimize the interest expenses.
  • Friends or family: You might consider borrowing from a family member or friend if you need funds for a short period of time and can't access a personal loan. However, this option comes with the danger of negatively impacting the relationship.
  • 401(k) loan: Another possible option is to borrow from your 401(k) account. The disadvantage with a 401(k) loan is that you're compromising your future retirement by withdrawing funds from the account. If you take money out of your 401(k) early, you won't be growing your money for your future, and you'll miss out on accruing interest. You also could be subject to fees and penalties. You should only consider borrowing from your 401(k) if you're in a dire financial situation.

Be selective about using a personal loan

A personal loan can be a helpful solution for some financial situations. If you're considering taking out a personal loan, ask yourself these questions first:

  • Can you reduce your total debt interest rates with a personal debt consolidation loan?
  • Are the personal loan payments within your budget?
  • Will the personal loan alleviate a potential disaster, such as the inability to pay a big tax bill?

If you answer yes to one or more of these questions, then a personal loan could be right for you.

Although you are allowed to use a personal loan for anything, look at both the advantages and disadvantages of the loan. The fact that personal loans don't require collateral is beneficial. And if you make your payments in a timely manner, a personal loan could help improve your credit profile.

On the other hand, whenever you borrow money, you're risking the possibility that you won’t have the cash to pay the loan back on time, thereby hurting your credit. Do your research and evaluate your personal financial situation before taking out a personal loan. If you take out a personal loan, make sure it’s for an important reason—and make sure to pay the funds back on time.

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Article copyright 7/5/2016 by The Motley Fool.
The statements and opinions expressed in this article are those of the author. Neither Fidelity Investments nor your employer can guarantee the accuracy or completeness of any statements or data.
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