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Personal loans may seem to be a good way to cover short term money shortages, including personal loans for new credit. However, there are advantages and disadvantages to getting a personal loan. Knowing the advantages and disadvantages of personal loans can help you make wise decisions.
A personal loan is one that is not secured by collateral. Collateral is something of value that you own that a lender can repossess if you don’t pay the loan. A home, boat or vehicle can be collateral that a lender can repossess. Personal loans, in contrast to collateral-based loans, are backed by your promise to repay the loan. Signature loans or unsecured loans are other names for personal loans.
There are numerous reasons you might want to get a personal loan. Several reasons for a personal loan are debt consolidation, college tuition, various education expenses such as schoolbooks, or wedding expenses. Some people use personal loans for vacations or to pay off credit cards. However, using personal loans for new credit is not a good reason to pursue personal loans.
Personal loans often have steeper terms than other forms of loans because personal loans are not secured with collateral. It is a greater risk for the lender to give you a personal loan because the lender cannot repossess the property if you don’t repay the loan. For this reason, there are high-interest rates for a personal loan and higher fees than other loans.
There are different amounts that you can borrow, but most unsecured loan amounts range between a minimum $1,000 and a maximum of $50,000. The rates usually for personal loans range from about 6 percent to 36 percent. However, the actual rate for a personal loan depends on several factors. Your credit score and history, your annual income, and the amount of debt you owe are all factors in securing a personal loan.
Simply applying for personal loans for new credit is not a guarantee you will get a loan. There are terms you need to meet as a borrower. You need to have a credit history, a good credit history, a steady source of income, and a low debt ratio. Credit history is a record of you paying off debt such as a mortgage or a credit card. Lenders, whether it is a bank or a credit card provider, report your paying off your credit to credit bureaus.
The credit bureaus keep records of your paying off debts to give you a credit score based on your paying back credit card or other debt. If you don’t have a credit history, then starting with a new credit card can help you create a credit history. The most useful cards to create a credit history are secured credit cards, retail cards where the provider reports your history to the credit bureau, or student cards. Be aware these cards may have higher interest rates since you are new to building a credit history. Don’t use subprime cards to build a credit history. Subprime cards often have high-interest rates and expensive fees. Interest rates for subprime cards may run as high as 30%.
A steady income that will cover paying off the debt is essential as is having a low debt ratio. Low debt ratios mean your debts are less than your ability to pay the debts. For example, if you have $500 in debt, but make $2000 a month your debt ratio would be low because you make enough money to cover the $2000 debt. However, for example, if you have $20,000 in debt but only $500 a month in income, your debt would be high in comparison to what you have to pay the debt back. This would be a high debt ratio, something that could work to your disfavor with a lender if you are considering personal loans for new credit.
There are many advantages to a personal loan. One of the advantages is that a personal loan can be a handy way to consolidate your debts in one place. If you are trying to pay several credit cards, it’s possible to roll all your bills into the personal loan. This may cut your interest rate. As of February 2019, the Federal Reserve reported the average rate of a two-year personal loan was 10.36 percent. The average rate on a credit card was 15.09 percent. Some personal loans, depending on the lender, may have rates as low as 6 percent or 7 percent. These low rates are for people with good credit histories, steady income, and low debt ratio. A person who uses personal loans for new credit needs to consider their credit history and score, debt, and income.
Another advantage of personal loans is the loans are unsecured. This means the lender cannot take your property if you cannot repay that balance. You don’t have to wait for a collateral appraisal on, for example, a house, car, or boat so you can receive an answer about your application quickly. Interest rates on personal loans are usually fixed, meaning the rates won’t change while you are paying off the loan. Another advantage is that personal loans have definite payment schedules and ends. A personal loan is paid on what is called “an installment plan.”
This means you pay the loan and a certain amount of the loan on a schedule set by the lender. For example, the lender may say you have to pay $100 each month to pay back the loan until the loan is paid. In contrast, a credit card is revolving credit. Revolving credit is a credit that is renewed as you pay off the credit debt.
The flexibility of revolving credit, while it is renewed, can lead to further spending and greater debt. This is why personal loans for new credit is not a good idea. When you pay off a personal loan, you are done with your loan obligation. Pay your loan installment payments on time and in full to establish a good payment and credit history with credit bureaus. Paying on time for each installment will help your debt decline, a consideration for maintaining a good credit history.
A personal loan for debt consolidation is not paying off debt. It is transferring the current debt to another form of debt. Furthermore, if you are still carrying other credit cards, you may still be gaining debt on those cards. Instead of digging yourself out from debt with a personal loan, you may be digging yourself deeper into debt.
Personal loans for new credit are not a good idea. It’s essential to establish your credit history with a credit score before considering a personal loan. Someone who lacks credit history or good credit history, or a person without a steady income or with a high debt ratio may be ineligible for a personal loan. Remember, the lender is not going to give you a loan on a promise because the loan is not backed up with collateral.
Furthermore, people who obtain personal loans for new credit without a credit history, with a bad credit history, with a lack of income, or who have a higher debt ratio often pay higher interest rates or personal loan fees than people who have a good credit history, a steady income, and low debt ratio. You should shop for a personal loan that reflects your credit history, credit score, income level, and debt ratio.
A big disadvantage of a personal loan is many financial institutions or banks will not allow you to make partial repayment of your loan. Your debt will become greater and greater if you do not pay your installments on time and with the full amount for the installment. This inability to pay on time and in full for the installment payment could negatively affect your credit history and credit score, making it harder for you to obtain any credit such as an auto loan or a mortgage in the future.
Personal loans often charge fees that are 1 percent to 4 percent or more of the amount you are borrowing. These fees are called origination fees and are in addition to the interest rates of the loan. Some lenders charge fees to prepay the loan before the loan terms are up or to ensure there will be money if you have late payments. Be careful when you compare personal loans. Always read all the terms and conditions of a personal loan before signing the loan papers. A large loan will often have additional and higher fees.
Not all personal loan lenders are legitimate. Research the lender before you pay origination fees or take out any personal loans for new credit. Find an accredited lender through the Better Business Bureau (BBB) website. The Federal Trade Commission (FTC) requires all lenders and brokers to have registration in the states where they have their businesses. You can find this information by contacting your state attorney general’s office. Common personal loan scams are:
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