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I recently called my bank to ask about fees for using my debit card on an upcoming international trip. I laughed when the banker followed up by asking, «Are you interested in taking out a personal loan for spending money on your vacation?»
There are plenty of good reasons to take out a personal loan, but going on vacation isn’t one of them. A personal loan is, in essence, an unsecured loan that you get on the basis of your credit and income – unlike a mortgage loan or home equity line of credit, which uses your home as collateral. Personal loans have advantages and disadvantages compared to secured loans, so whether you go for one of these when you’re in need of cash depends on your individual situation.
1. The interest rate may be higher than you expect
When you hear about interest rates in the media, they’re often talking about the 30-year fixed rate for a standard mortgage, which has been around 4 percent or lower for a long time now. But a personal loan’s interest rate will probably be at least twice that. The reason for the difference: When you refinance your home or take out a home equity line of credit, you’re promising to relinquish your home if you can’t pay back the debt. That’s a bigger risk for you, and less of a risk for the bank, compared to a personal loan. In return, banks give you a low interest rate on secured loans. (See also: The Different Types of Loans: A Primer)
2. Your credit score matters more for personal loans
With no collateral, all the lender has to go on is your personal creditworthiness. You can expect the available interest rates to increase steeply if your credit is average or poor, going up as high as 36 percent APR.
3. A personal loan is not a long-term solution
While the typical mortgage is paid off over decades, personal loan terms are typically limited to seven years or less. This can be a good thing, because you should never borrow money for longer than you really need to. But it also means that if you are trying to borrow a lot of money, like for a major home remodel, the payments might be too high for you to keep up with on a personal loan.
4. Banks aren’t the only option
As nonprofits, credit unions often offer lower rates and fees than banks for the same personal loan products. Then there are the crop of new «marketplace lenders,» such as SoFi and Prosper, which promise easy, quick online loan approval and good rates, especially to folks with the best credit. This nascent industry has had some bumps in the road, but it’s still an avenue worth looking into. (See also: Best Lenders for Personal Loans)