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Personal Loans 101: When Do They Make Sense?

By following some simple do’s and don’ts, you can make personal loans more effective for your finances—and your life.

by Navy Federal on June 28, 2018 | Tag(s): Personal Finance

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At some point in your life, you may be interested in a personal loan. It can open the door to a variety of possibilities that otherwise wouldn’t be immediately available to you due to a lack of funds, such as a computer or home improvements. Like most loans, you’re able to pay off a personal loan over time at agreed-upon terms with a lender—typically with fixed interest.

Unlike the typical mortgage or auto loan, personal loans are generally unsecured. Lenders take more of a risk when making unsecured loans because they won’t have assets to recover in the case of default. For example, when a borrower defaults on a secured auto loan, a lender can repossess the vehicle and sell it to help pay off the loan. However, if a borrower defaults on an unsecured loan, there's no collateral that the lender can recover and sell. Because unsecured loans are riskier for lenders, they're more difficult to get, often have higher interest rates and depend on your creditworthiness. While personal loans don’t have assets that can be taken like secured loans do, the lender can still undertake general collections activities in an effort to recover on a defaulted unsecured loan.

YES, a personal loan may be a good idea for:

  • home renovations: Have you always hated that old bathroom? If you don’t have equity built up in your home, taking out a personal loan to fix up a section of your home may increase the value of your house and help you build credit at the same time. (If you do have equity in your home, a home equity loan or line of credit may offer better financing options with lower rates and possible tax advantages.)
  • debt consolidation: Because credit cards (especially store cards) may carry higher interest rates, consolidating debt from a credit card to a personal loan may be a smart idea.
  • career advancement: Even after you have a college degree in hand, some additional certifications and training can pay endless dividends for your future career prospects in the form of promotions, new jobs and more.
  • unexpected expenses: It can happen to anyone at any time. A tree falls through the roof of your house, you have a family emergency or your car is totaled in an accident. You may need a personal loan to help you recover from sudden, expensive inconveniences.

NO, avoid personal loans for:

  • extravagant vacations: Always wanted to backpack through Europe or spend the summer in the Caribbean? A personal loan shouldn’t be your way to fund an elaborate vacation if you'd have trouble paying it back. While a personal loan can be a fine way to finance a honeymoon or an important trip to visit family or friends, be careful not to borrow more than you can afford to pay back. Extravagant spending can bring you home broke.
  • weddings/birthdays/graduations: Parties aren’t the best use of personal loans if you spend more than you can afford to pay back. If the loan payments are reasonable for your budget and the event is a top priority for you, then a personal loan may be worth considering, but don’t bury yourself in payments for events that only last a day.
  • extra spending money: Whatever the reason, taking out a personal loan to afford a lifestyle your current finances can’t support generally isn’t recommended.

This list isn’t exhaustive, and it’s important to recognize that there may be times you think you need a personal loan when cutting your expenses or picking up a part-time job might work just as well. A good rule of thumb is to see if the purpose of your personal loan will improve your financial standing once it’s paid off.

Navy Federal Credit Union can assist you in weighing the benefits of a personal loan and help explain the options available to you.

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This article is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.