Last year, I had a medical emergency and spent some time in the hospital. Despite having good insurance, I still received a huge bill. I blew through my emergency fund to pay down the debt, but I still had several thousand I needed to pay. To avoid my account going into collections, I paid off the remaining balance with a credit card.
While that worked in the short-term, it caused more headaches down the line. Thanks to interest rates, my balance began to balloon and it became more difficult to make any progress.
I decided to take out a personal loan to wipe out that credit card debt. My new loan had a much lower interest rate, so more of my payments went towards the principal rather than interest. Taking out that loan helped me become debt-free much faster.
While a personal loan was a smart choice for me, they’re not for everyone. Here’s what you need to consider before applying for a loan.
1. Your Financial Need
You can take out a personal loan for many different reasons. You could use it to consolidate your debt, fix your roof, pay for a wedding, or even to buy furniture. In most cases, the lender doesn’t care how you plan on spending the money; they only care how you’ll pay it back.
But before taking out a personal loan, consider why you need the money. If it’s to purchase a splurge or a dream vacation you couldn’t otherwise afford, it’s likely not a wise decision to apply for a loan. However, in the following scenarios, borrowing could be a smart idea:
Repay debt faster: If you have high-interest debt, using a personal loan to consolidate your balances and get a lower interest rate can help you save money. And, you’ll pay off your debt much faster.
Cover an emergency: If there’s an emergency, such as a medical bill or a car repair so you can get to work, a personal loan can be a way to cover the bill. It’s not ideal, but it’s a lower-interest solution than relying on credit cards or payday loans.
2. The Amount You’ll Borrow
How much you want to borrow will impact what lenders will work with you. Some lenders have minimum borrowing amounts, such as $5,000, and limits on the maximum you can borrow.
When applying for a loan, it can be tempting to tack on a few extra thousand so you have more cash on hand. But, interest will accrue on the full amount you borrow. That few extra dollars could end up costing you hundreds or even thousands over the length of your repayment term.
For example, say you borrowed $10,000 at 10% interest with a 60-month repayment term. If you made only the minimum payments, you would pay back $12,748 over the length of your loan. However, if you borrowed just a little more, the interest charges can really add up.
If you borrowed $12,000 at 10% interest with a 60-month repayment term, you’d pay back $15,298. Although you only borrowed $2,000 more than the $10,000 loan, you’ll pay $2,550 more in interest charges.
3. Monthly Payments
Before applying for a loan, think about what you can really afford. If you haven’t already, create a detailed budget with all of your expenses, including rent, clothes, groceries, utilities, transportation, and entertainment. The money you have left over after you account for your expenses is what you can afford to pay each month towards your loan payment.
You could lengthen your repayment term to reduce your monthly payment, but that means you’ll pay more in interest over time.
If you took out $10,000 at 10% interest over five years, your monthly payment would be $212 and you’d pay $2,748 in interest.
However, if that payment is too high, you could extend the term to 10 years. The longer term would drop your payment to just $132 a month. But, you’d pay more than double in interest fees. You’d pay $5,858 in interest.
4. Interest Rates
Your interest rate has a huge impact on your monthly payments and how much you’ll pay back over time. Depending on your credit, you might end up paying a much higher interest rate. Someone with excellent credit could get a personal loan with an interest rate as low as 7%. But, those with bad credit may only be able to get a loan with an interest rate of 29.99%.
At first, you might not think the interest rates are such a big deal. However, they can cost you thousands. If you had a credit score of 810 and a lender approved you for a $10,000, 60-month loan at 7% interest, you’d pay back just $11,881 in total.
But, if you had a credit score of 550 and could only get the same loan at 29.99% interest, you’d pay back a whopping $19,408. That’s nearly double the amount you originally borrowed.
When to use a personal loan
A personal loan can sound appealing when you’re planning a big purchase or want to pay down debt. But before submitting a loan application, make sure you understand how much you’re borrowing and how much you’ll pay over time. If you’re not careful, you could end up with a loan balance that’s thousands more than you started with at the beginning.
After doing your homework, you might decide a personal loan is right for you and your situation. If that’s the case, you can complete one easy form and get multiple loan offers from several different lenders through CreditSoup.
Editorial Disclaimer: Information in these articles is brought to you by CreditSoup. Banks, issuers, and credit card companies mentioned in the articles do not endorse or guarantee, and are not responsible for, the contents of the articles. The information is accurate to the best of our knowledge when posted; however, all credit card information is presented without warranty. Please check the issuer’s website for the most current information.