BasicsSavings&Banking

Pros and Cons Of Personal Loans. Everything You Need To Know

TL;DR: The advantages of personal loans include convenience, flexibility, low-interest rates, and security. The disadvantages of personal loans include regular monthly payments, the potential for debt cycling, and inflexible payment rates.

Sometimes you need a bit of extra cash on hand. Whether you need some extra money to make some home improvements, pay off some of that mortgage, or get rid of that nasty credit card debt, nobody ever doesn’t want some extra funds.

A personal loan can be a viable option in those situations where you are just a bit short.

Used wisely, a personal loan can be a smart decision that can balance a budget and give you a bit more financial flexibility.

We cover some basic fundamentals of personal loans talk about when they are a good idea, and what the advantages and drawbacks are.

First, let’s talk a bit more about how personal loans work.

How Do Personal Loans Work?

When you take out a loan, you are basically borrowing a lump sum of money with the promise to pay it back in regular installments, plus interest.

Most personal loans in the UK have repayment periods of 3-10 years with interest rates that can range from 5% to 36%.

Here is a quick example to show you how it works. Say you take out a personal loan for £10,000 for a period of 5 years at a 10% interest rate.

Doing a quick calculation, that comes out to £2,748 in accumulated interest over the 5 year period.

So you would end up paying £12,748 over the lifetime of that loan.

Dividing that number by 60 months, we get an average monthly payment of about £212.

The above example is a bit simplified as it does not take into account any fees or other charges, but it illustrates the basic point well.

Various factors go into determining the exact terms of the loan such as your employment history, credit score, debt to asset ratio, and more.

The lower the interest rate, the less in extra interest you will end up paying over the life of the loan.

Most personal loans have fixed interest rates so you will be making the same monthly payment during the repayment period. If the interest rate is not fixed, then monthly payments may differ.

Secured vs. Unsecured Loans

Personal loans can also be secured or unsecured.

With a secured loan you put up some sort of collateral which the lender has the right to seize if you default on the loan.

A mortgage is a kind of secured loan where the property itself is the collateral.

In contrast, an unsecured loan does not have any collateral and is based solely on your creditworthiness.

If you default the lender cannot take your property but your credit score can be ruined, and the bill could go to collections.

The majority of personal loans are unsecured so lenders cannot take any collateral. There are still consequences for defaulting on these loans, but they are not as severe as having your assets seized.

Some organizations may offer secured personal loans which generally have lower interest rates.

If you default the lender cannot take your property but your credit score can be ruined, and the bill could go to collections.

What Can I Use a Personal Loan For?

Strictly speaking, you can use a personal loan for pretty much whatever you want, barring illegal transactions.

However, many lenders might not give a personal loan if they think you will use it for something they do not want you to use it for.

For instance, many lenders will not give out personal loans to buy property, cover gambling debts, invest in the stock market, or to cover late fees on other bills.

In most cases, your loan agreement will specify which activities you agree to use the funds for and which ones you agree to not use the funds for.

One of the most common reasons people take out personal loans is for debt consolidation.

With debt consolidation, you take out a loan to cover your existing debts, then focus on paying back that loan, usually at a lower interest rate.

Personal loans are a viable method for managing credit card debt, for instance, as personal loans usually have much lower interest rates than credit cards.

Keep in mind that taking out a loan for debt consolidation does not get rid of your debt; it just puts it in a different form.

Most of the time you end up paying back more than the initial amount you owe due to interest and other fees.

A personal loan can help you get more manageable monthly payments on that debt.

Personal Loan Pros & Cons

Pros

Convenience

One of the biggest advantages of personal loans is that they are convenient and quick.

A personal loan can be a solution if you are put in an unexpected bind and you need some time to get back on your feet.

Most lending institutions allow you to apply or a personal loan online and can be approved in as little as 24 hours.

Most personal loan applications require basic information like your income and credit so they can determine appropriate loan terms.

Forms and requirements may differ depending on the lending institution.

Flexibility

With the exception of a few key things, you can basically use a personal loan for whatever you want.

You can take out a personal loan to finance that kitchen rebuild you’ve been wanting to do, handle that credit card debt, or even take an early vacation.

The only limitations are the particular terms of the loan.

Lower interest rates

Personal loans generally have lower interest rates compared to other kinds of debt such as credit cards.

If you have a bunch of high-interest debt, consolidating that debt with a single low-interest personal loan can be a viable method for getting monthly payments back into the manageable territory.

The exact interest rate you will get depends largely on your credit score and income.

In general, the higher your credit score is, the lower the interest rate you can qualify for.

Your credit score is an important factor that determines the interest rate but not the only one.

Other factors include income, employment history, and debt/asset ratio.

Cons

Longer payment period

If you use a personal loan to consolidate other debts, then you will end up paying back that debt over a longer period.

You will usually have lower interest rates though, so your monthly payments will be lower.

Once again, a loan for your debt does not get rid of your debt, it just makes it change form.

If one of your main worries about debt is how long it will take to pay off, taking a personal loan can make the repayment period even longer.

Debt trap

With a personal loan, as with any kind of debt with interest, you can get caught in a debt trap where it is infeasible to pay off their debt.

A debt trap is when interest rates are so high that you cannot chip away at the remaining principal.

The result is the debt balance never actually goes down and you are just paying interest.

Debt traps are most common with high-interest loans but they can happen with low-interest loans if you are not careful.

Extra fees

Aside from the principal and interest, most personal loans have other fees such as processing and administrative fees.

Some lenders might charge an “origination fee” which covers the cost of loan processing.

If you do not read the terms of your loan carefully, you could get ambushed by hidden fees.

Potential for scammers

The personal loan market is, unfortunately, a hotbed for scammers and other unscrupulous types.

Make sure you do your research with a particular lender before signing anything. One great resource is to check the Better Business Bureau to see if the lender is legitimate and accredited.

Final Thoughts

When used wisely and with temperance, personal loans can be a viable solution when you find yourself in a financial tight spot.

They can help manage expenses when you do not currently have the requisite funds and they can be used to make existing debts more manageable to pay off.

The key things to keep an eye on are loan interest rates and payment periods.

Tom
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About author

Fully qualified CISI Investment adviser for 5 year. Managed UK private client portfolios.
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