Banks and credit unions will often offer you “personal loans”, but is there a worthwhile use case for them?
Debt is a drag on your ability to build wealth.
I don’t believe, like some do, that you can use leverage (i.e. debt) to build wealth. Sure, there are real estate gurus that openly espouse taking out as much in loans as possible to buy larger and larger properties, but to me that sounds like a house (or apartment) of cards.
Some types of debts are obviously bad. Credit cards offer instant gratification, but at an eye-wateringly high interest rate (currently over 25%, according to Forbes). Sure, you can pay the cards off each month, until something happens and you can’t.
Buy now pay later (BNPL) services are awful too, because they allow you to tell yourself that even though you can’t afford something today, somehow you’ll be able to afford it if you spread it out in time. This works in principle, until you make it a habit and your past purchases combine with your present ones to create an untenable situation.
Mortgages suck, but so do home prices, so it’s a wash. Car loans are mostly unnecessary with planning and appropriate expectations.
But what about the “personal loan”? Is there a purpose to those?
I’ve been getting a bunch of advertisements to apply for a personal loan myself. So let’s take a look.
Table of Contents
What is a personal loan?
A personal loan is a loan granted to you for “personal”, or elective reasons. If that sounds vague to you, Investopedia backs me up:
A personal loan is an amount of money you borrow to use for a variety of purposes. For instance, you may use a personal loan to consolidate debt, pay for home renovations, or plan a dream wedding.
So it’s a “choose your own adventure” loan.
Most of the time, this kind of loan is “unsecured”, meaning that there is no collateral for the loan. (Contrast this with a car or home loan, which is “secured”.) An unsecured loan usually has a higher interest rate, to account for the fact that there is nothing that the lender can repossess if you stop paying.
But it’s still a loan you can get for whatever you want. What’s not to love?
What can you do with a personal loan?
The first problem is that loans aren’t free money. You have to pay the money you get back, and with interest.
This would seem self-evident, but judging from the numbers of people who get into trouble with loans, it seems worth reiterating.
So, why would you get a personal loan?
As stated above, some reasons might be: to consolidate debt, pay for home renovations, and to plan a dream wedding.
Let’s put the debt consolidation aside and focus on the other two, which fall under the umbrella of “paying for big stuff.”
A home renovation and a wedding can be, of course, very expensive projects, easily topping five figures. Many people don’t have five figures lying around, and so might be tempted into a personal loan.
But again, here’s the thing: you have to pay this loan back. And unless you’re getting a ton of wedding presents, or you’re planning on flipping this home shortly, or you’ve got a big windfall in your future, your financial situation isn’t going to be all that different later than it is now.
So here’s an idea. Instead of getting a personal loan and having to pay really high (unsecured) interest rates for an unknown period of time, why don’t you start “paying the loan back” before you get the job done?
Just create a savings bucket, and put money into it each month, the same amount you’d be using to pay that personal loan back.
It takes a little bit of pre-planning, but not as much as you think. And remember that “paying” a few hundred dollars a month, or whatever rate you’d be paying the loan back, is free if you do it without a loan. This will cost you much less money.
What about a consolidation loan?
Credit card interest rates are high. And if you’ve racked up credit card debt, you’re probably feeling the pinch of all that interest you’re paying. It sucks, I know.
A personal loan can afford you the option of paying off one or more credit cards (with high interest rates), switching to a lower rate on the personal loan.
This has much more potential. A lower interest rate means less drag on your ability to build wealth.
But herein lies a trap if you’re not careful: if you’re used to using credit cards and you’ve piled up some debt, moving the debt to a personal loan may cause you to just pile on more debt.
Say you’re the type of person who uses a credit card until it’s maxed out. If you move that debt to a personal loan, then you might look at your credit card see that it’s totally clear and empty. Now you can use it again!
You see the issue, I hope. Consolidating debt without any behavior change may lead you to accrue even more debt, putting you in a worse situation overall.
So if you’re thinking of using a personal loan to pay off credit card debt, you have to stop using that credit card! There is no way around this. Learn to pay with your actual money, and not your credit cards. In other words, start to pay with your debit card. Take my word for it, that alone is one of the most powerful financial transformations you can make.
A personal choice
Banks love loans because they make money on them. Therefore, they are going to want to try and sell you a loan, whether or not you need one.
You never “need” a personal loan, but in some limited circumstances, it might be advantageous, especially:
- If you’re about to come into money soon and can pay it back, or
- If you’re willing to change some financial habits going forward
If either of those apply to you, then maybe a personal loan makes sense. Otherwise, you probably want to stay away.
