More people are turning to personal loans to pay for everything from a fabulous vacation to a new wardrobe to their credit card bills. Should you?
New year, new debt.
Americans are increasingly turning to personal loans — loans with short terms of just 1-5 years, in small amounts from $1000 up to about $50,000 — to smooth over their financial woes.
Data from Transunion shows that there were a record number of personal loans in 2017: 17.5 million in the third quarter — the latest data available — up from just 12.5 million at the same time in 2014. Their balances are creeping up, too. Transunion estimates that by the fourth quarter of 2018, the average debt per personal loan borrower will hit $8,461, up from an estimated roughly $8,000 at the end of this year and about $5,900 in 2011 and 2012. And as more players enter the field, Transunion predicts “even more growth in balances and volume of loans.”
People take out personal loans for a variety of reasons — everything from debt consolidation (the top reason) to buying a trip to stocking their closet for the season. Sometimes those reasons make sense, but other times they don’t. Here’s what to take a personal loan out for, and what not to:
Shopping and vacations: A survey by personal finance comparison site Finder.com found that shopping and vacations are among the top five things people regret taking out a personal loan for — and experts say it’s a big no-no- to do that anyway. “It’s never a good idea to take out a personal loan — or any debt for that matter — for something you don’t need,” says Ben Luthi, a personal finance expert for loan site Student Loan Hero.
“The only time I’d recommend breaking this rule is if you’re using the money for an experience that you must pay for now, but that you know you have the money coming to pay for in the near future,” says Jeff White, a financial analyst with FitSmallBusiness.com. “An example would be using the personal loan to pay for a trip to your family reunion when you already know you have a tax return coming that will cover the costs of what you’re borrowing. That’s a good investment in yourself and your life.”
Luthi notes that people like personal loans because you don’t have to put up an asset (like, say, your car) as collateral, but “that also means they charge higher interest rates.” Indeed, interest rates on some personal loans can be high — up to 36% even, on top of the fact that many lenders charge fees to initiate the loan and some have prepayment penalties to discourage you from paying the loans early.
Debt: “The most common reason people take out personal loans is for debt consolidation”– and more people are likely to do this because our credit card debt has hit records, says Robin Saks Frankel, a financial products writer and reviewer for Bankrate.com. Indeed, the Federal Reserve announced in January that credit card debt, as of November, had hit a record high (more than $1 trillion). And we likely just added to that over the holidays: A survey from MagnifyMoney at the end of December revealed that Americans racked up an average of $1,054 of debt this holiday season, up 5% over last year.
In this case, it can be smart to tap a personal loan. “Personal loans can be great because they allow you to consolidate your multiple debts and potentially lower the interest rate you’re paying,” says Maggie Germano, the CEO and founder of Maggie Germano Financial Coaching. “I’ve had clients that have four- five credit cards to pay off, and the multiple bills and varying interest rates stress them out and make it more difficult to manage. Taking out a personal loan allowed them to transfer five accounts into one and have one lower interest rate. This saved them money and stress over the long term.”
Using them for some other kinds of debt can make sense too, says Chantel Bonneau, a wealth advisor with Northwestern Mutual: “You might consider a personal loan if you are in a bind and no other option – for example an unavoidable medical bill.”
To do this smartly, be sure that the interest rates the personal loan is charging are lower than the interest rates on your debt — and consider the fees charged by these loans (including potential origination fees and prepayment) into the total cost. And, says Luthi, “make sure you consider all your options before you fully commit. For example, there are some credit cards that offer 0% APR promotions … Some of these cards offer close to two years with no interest.”
A home improvement project: Luthi says it can make sense to use a personal loan to finance a renovation on a home you own. Indeed, renovations can add value to your home — such as these projects, all of which cost $1500 or less.
Still, before you opt for a personal loan, Luthi says you should “consider other ways to finance your purchase … For example, do you have time to save up for a home improvement project?” And, he adds, “if you do choose to go through with a personal loan, make sure to shop around and compare loans from several companies. Some lenders even allow you to get a look at your interest rate before you officially apply.”
Bottom line: No matter what reason you opt for a personal loan, perhaps the biggest reason personal loans can be detrimental to Americans is that those who already have the most trouble paying down their debt are the ones who are often most likely to turn to these loans for help. “If you think you may have a similar problem in the future (during repayment of this loan) then it’s generally not a good idea to take out the loan because defaulting will only get you in worse financial trouble then you already believe you’re in,” says White.
Or, as Germano puts it, “Personal loans [can be] a helpful bandaid but they won’t solve the deeper issue at hand.”
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