Types of Personal Loans: Pros and Cons
When Should You Apply for a Personal Loan
Nearly everyone has needed cash to cover some emergency, to make a large purchase or to consolidate some haunting debts.
That is to say, at one time or another, nearly all of us has needed some extra cash we didn’t have access to. In such situations, a personal loan is among the most common and most useful financial tools in our arsenal.
When you request a personal loan, the lender will usually lend you an amount ranging from a few hundred to a few thousands of dollars in different conditions. The term of the loan can vary from several weeks to a few years, usually for a fixed interest rate and perhaps several nominal fees.
What Types of Personal Loans are There?
Choosing which type of personal loan is best for you can sometimes seem daunting. In this article we will be analyzing the pros and cons of the main types of personal loans, as follows:
- Unsecured Personal Loans
- Secured Personal Loans
- Fixed-Rate Personal Loans
- Variable-Rate Personal Loans
Advantages and Disadvantages of Unsecured Personal Loans
A personal loan is called unsecured when it is not secured by any collateral. It means it will not be necessary for the borrower to offer specific assets as protection. In case they fail to repay the loan, they risk nothing but the amount of interest and financial charges. Most personal loans are unsecured. That is why most personal loan lenders tend to charge higher interest rates than for an auto loans, which is secured by the vehicle, or a mortgage, secured by the property.
Pros of Unsecured Personal Loans
Regular payments for the term of the loan.
The pre-determined installments will allow you to budget for loan payments.
No risk of losing your personal property.
If you can’t pay back the loan, you won’t lose your house or your car.
Unsecured personal loans don’t need certain paperwork, such as proof of asset ownership or the need for third-party approvals to put up personal assets as collateral, so there are fewer forms to fill out.
It can improve your credit score.
While those with less-than-perfect credit scores may have a more difficult time getting a loan at a low interest rate, the good news is, paying off the loan, even a short-term personal loan may have a positive effect on their credit score.
Cons of Unsecured Loans
They are more difficult to qualify for.
Because the borrower isn’t putting up collateral, the lender will often require a higher credit score to qualify.
They cost more.
In addition to making it harder to qualify, unsecured loans often feature higher interest rates as a trade-off for not having to provide collateral.
The amounts tend to be lower.
The general rule of thumb is, the higher the loan amount, the more likely it will need collateral. Small personal loans don’t need collateral because they’re small, so you’re not likely to find an unsecured loan large enough to buy a house.
Advantages and Disadvantages of Secured Personal Loans
A secured personal loan is a type of loan in which you are asked to put up some personal assets as collateral. Among the most common types of unsecured loans are auto loans and home loans. Secured debt refers to any type of debt that is backed by some sort of collateral. By providing collateral, the lender can take possession of your property if you fail to pay.
Pros of Secured Personal Loans
Lower rates and fees.
Because the lender is taking on less risk, given the security you are putting up, the interest rate is likely to be lower than that for an unsecured loan.
Larger amounts available.
Because they know they can recover more of their money, even if you fail to repay the loan, lenders are more likely to lend larger amounts than with an unsecured loan.
Cons of Secured Personal Loans
Much greater risk to you.
From the perspective of the borrower, the greatest downside of taking out a secured loan is the prospect of losing the asserts you put up if you are unable to make all necessary payments on the loan.
In addition to the prospect of losing your collateral, secured loans usually feature longer terms, although that is often up to the borrower. Because there are larger amounts available for secured personal loans, borrowers often prefer to spread the payments over longer terms. That is why most mortgages are 30 years. Be careful, however, and read the contract, since many lenders will penalize borrowers who pay off their debt too quickly.
Advantages and Disadvantages of Fixed-Interest Personal Loans
A fixed interest loan is the type of loan in which the interest doesn’t fluctuate over the entire life of the loan. For instance, when you’re looking at a 5-year fixed-rate personal loan at 10%, the interest will stay at the lever for the entire 10-year term.
Advantages of Fixed-Rate Personal Loans
A high level of certainty.
Many people prefer a fixed-rate loan because it offers certainty. For budgeting purposes, this can be invaluable. You know what your loan payment will be for the entire loan term, even if it’s a 30-year mortgage.
A lot of potential savings.
If interest rates go up, you have the knowledge that your mortgage will never increase. If interest rates rise in the future, being locked into your current rate could save you thousands over the life of a long-term loan.
Disadvantages of Fixed-Rate Personal Loans
You could end up paying more.
On the other hand, if interest rates drop, you could miss out on thousands of dollars in savings, especially if you are locked in at a relatively high rate. For example, if you have a less-than-perfect credit score and you are locked in at 10 percent, you could lose a lot of money, should your credit score drop in the future.
Advantages and Disadvantages of Variable-Interest Personal Loans
A variable-rate loan is any type of loan where the interest rate can change over the life of the loan. These can be unsecured or secured, and the most common examples are adjustable-rate mortgages 9ARMs) or credit card accounts. Essentially, a variable-rate loan is much like a bet.
If you are considering taking out a variable-rate loan, you should be very careful. Pay attention to current trends with regard to interest rates and carefully consider the term of the loan. The longer the loan’s term, the greater the impact of either an increase or a reduction in interest rates on your loan.
Pros of Variable-Interest Personal Loans
You could pay less.
If the prime bank interest rate set by the Federal goes down, it’s great for the borrower. Over the past decade or so, with the prime rate hovering close to zero percent, variable-rate borrowers have done quite well. Many of them pay far less interest than fixed-rate borrowers, which means they may be saving significant monthly amounts that can sum up to thousands of dollars over the life of the loan.
Cons of Variable-Interest Personal Loans
You could pay more; a lot more.
The flipside of the “bet” you are making is that interests could go up, and that is to the advantage of the lender and to your detriment. Such loans offer a lot less certainty, which means they can potentially cost you a lot more over the life of the loan.
Which Type of Personal Loan to Choose?
Most experts recommend that you sit down with a financial or loan advisor and carefully analyze your entire financial history. Before you know where you need to go, you have to know where you are. It’s entirely possible to find a way to do what you have to without borrowing money!
Before you make a decision, explore all options available and by all means, consider the pros and cons of every option.
- “Fixed and Variable Rate Loans: Which is Better?” – https://www.investopedia.com/ask/answers/07/fixed-variable.asp
- “How to Choose a Financial Planner” – http://guides.wsj.com/personal-finance/managing-your-money/how-to-choose-a-financial-planner/
Kerry Vetter is a consumer finance expert and writer, who has been engaged in creating finance-related content for more than ten years. Her expertise is approved by obtaining a Bachelor of Science in Finance from Boston College, as well as receiving three major certificates as a professional advisor and counselor. At the moment, Kerry is an author of multiple educational articles and insights that have been created in order to increase and develop financial literacy and responsible borrowing among US citizens. Her expert relevant savings advice has helped a lot of people overcome their financial issues and find out more about principles of smart spending, the right investment decisions, and budgeting. You can read more about Kerry’s professional background here.
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