How does a personal loan work?
A personal loan allows you to borrow money to pay for something or to consolidate your debt. As soon as you receive the lump sum amount, you begin repaying it over the agreed payment period, called a term, plus interest and fees.
Personal loans can be beneficial when you need help getting on top of a big or unexpected expense if you don’t have the savings to fund it.
Personal loans are just one option for borrowing money, and come with both benefits and risks, depending on your specific needs and circumstances.
What are the pros and cons of personal loans?
Like all credit options, there are pros and cons associated with a personal loan. What is a benefit for one person may be a risk for another. So it's important to do your research and weigh up the options before committing.
Here are some of the factors to consider to help you work out if getting a personal loan is right for you:
Three potential benefits of a personal loan
In the right circumstances, personal loans can be advantageous because:
1. You can use them to consolidate existing debt
You could take out a personal loan to pay off some or all of your existing debts (including credit card debt and other loan products). If you can get one with a lower interest rate than you're currently paying, you could find having a single, smaller monthly repayment easier to manage than multiple fees and repayments.
2. They can be flexible
Personal loans can be used for many purposes, such as consolidating debt, paying for weddings and holidays, and to pay off unexpected expenses, such as car repairs. They're relatively easy to apply for and some can be approved quickly if you need fast access to cash.
Personal loans have a range of options. For example, you can have an unsecured or secured loan, with a fixed rate or a variable rate. They also come with a variety of term lengths (generally between one and 10 years) and some provide the option of weekly, fortnightly or monthly repayments.
While lenders may not lock you into how to use the money (except with a car loan), some may specify a list of approved uses for the loan. This is something to check before applying.
3. Some competitive interest rates may be lower than credit cards
Personal loans may come with lower interest rates than some credit cards. Furthermore, you may be able to apply to borrow a higher amount than on a credit card, if you're confident you can make the increased repayments. But this usually depends on the type of loan being offered.
Keep in mind your credit score can influence your borrowing options, including how much money a lender approves you to borrow, plus the interest rate that applies.
Three potential disadvantages of a personal loan
Some of the potential disadvantages of a personal loan:
1. Fees and interest rates can be high
Personal loans can come with high fees, interest rates and penalties that drive up the true cost of borrowing. While they can have lower interest rates than other options, such as some rewards credit cards, you may find that the interest rate is still high.
Further, borrowers with poor credit may end up paying higher interest rates than via a credit card. If you have savings or can wait and build a fund of cash, paying for your expenses with your own money may be preferable.
2. You're locked into a contract
Personal loans lock you into a set payment period. Plus, depending on the type of loan you apply for, you may have to make a balloon payment (usually on car loans) or you could be penalised for paying off the balance of the loan before the end of the term.
Be sure to review all the associated fees and possible penalties before applying for a loan.
3. Personal loans increase your debt
Carefully consider if your reason for taking out a personal loan is worth the possible long-term financial strain. Be mindful of overspending and taking on too much debt. When your debt becomes unmanageable, it can affect your ability to save money and pay other bills on time.
Will a personal loan help or hurt your credit score?
Applying for a personal loan can impact your credit score. Used responsibly, your credit score could improve if you consistently meet your repayments and practise healthy money habits.
Additionally, using a personal loan for debt consolidation can reduce your number of open credit accounts and help your score.
On the other hand, while a personal loan may seem like a good short-term solution, if you haven't properly budgeted to make on-time payments over the duration of the loan term, late payments and defaulting can harm your credit score.
Also note that when assessing you for credit, lenders will look at all your debts, plus all accessible credit facilities, including credit card limits.
Higher debts and credit limits will negatively impact your ability to take on more debt, for example a mortgage. So if you're planning on applying for a home loan, it's a good idea to first pay off other loans and reduce your credit card limits.
What about bad credit loans?
If you have a poor credit score, it may affect the loans or credit for which you can apply. Potentially, you may find you're only eligible to apply for a loan for borrowers with poor credit scores.
But be cautious before choosing this option. Not only will you pay a higher rate of interest, if your credit score is already low, applying for a new loan could impact it further, as each loan application you make is generally recorded on your credit report.
If you're concerned about your credit score and your ability to meet loan repayments, carefully consider if this is the right option for you.
Is a personal loan is right for me?
If you're unsure whether a personal loan is the right choice for you, you may want to consider talking to a financial advisor.
