Pitfalls of Personal Loans

For some trying to consolidate credit card balances, or make a major purchase, a personal loan can look like an attractive option. The bank gives you a lump sum, and you pay it back gradually over a few years with interest. Personal loans can seem more attractive than credit cards, but keep in mind that personal loans come with their own challenges and drawbacks.

– Unlike a credit card, your balance is maxed out immediately, you are charged interest on the entire balance and your payment is set based on the entire balance. With a credit card, you can use part of the credit line and only owe payment on the part you use. But with personal loans, you are given the lump sum immediately, which results in a higher monthly payment. And while credit card balances can be easily paid off, the sheer size of a personal loan makes paying it off a more deliberate, costly process. Some banks may even charge you fees for paying a personal loan off early.

– Personal loans are more difficult to get than credit cards. As long as you have a high credit score and no delinquencies on your credit record, getting approved for a credit card is as simple as applying and receiving notification of approval before getting a card a week or so later. With personal loans, however, you must undergo a more formal application process, and your financial history is more tightly scrutinized.

You still receive word within a couple days, but chances of receiving a rejection are much higher, because of the aforementioned difference between credit cards and personal loans. A personal loan is an investment by the bank in you: Banks want to be sure they’ll see a return on their investment in you, so they’re more careful about whom they approve personal loans for than for credit cards.

– They come with relatively high interest rates. The base rate for a credit card can typically run in the 15-25% range, maybe 10-15% if you’re lucky. Personal loans typically feature lower interest rates than this, but not by much. If you’re fortunate, you can find a personal loan for 7-8%, though typically your interest will accrue at a 10-15% rate. This can save you money if you’re consolidating high-interest credit cards, but some credit cards offer an introductory or balance transfer special period, where you get 0-2% interest on any balances transferred or incurred over 18 months. Such a credit line may be a more valuable place to consolidate your debt than with a personal loan.

– And most of all, missing a single payment on a personal loan can prove more costly than missing a credit card payment. Credit cards will simply bill you a fee and spike your interest rate if you miss a payment. That’s a stiff penalty, but nothing compared to the penalties for missing a personal loan payment. Many banks, however, may default your loan if you miss one or two payment, and could even call for immediate repayment of the full balance. Even if you resolve the issue, good luck getting any credit again in the foreseeable future, as the delinquency will get reported to the credit bureaus.

Personal loans offer a financing advantage over credit cards and other financing, but they also lack some of the flexibility of the other options, and can lead to bigger problems than you can handle if you’re not comfortable. Certainly don’t let these pitfalls preclude you from seeking a personal loan if it’s still your best option, but keep the pitfalls in mind when considering whether or not to get one.