The Pros and Cons of Personal Loans

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How does a personal loan work?

A personal loan allows you to borrow money to pay for something or to consolidate your debt. As soon as you receive the lump sum amount, you begin repaying it over the agreed payment period, called a term, including interest and fees.

Personal loans can be beneficial when you need help getting on top of big or unexpected expenses if you don’t have the savings to fund it. But keep in mind that loans need to be paid back along with interest and fees.

Personal loans are just one option for borrowing money, and come with both benefits and risks, depending on your specific needs and circumstances.

What are the pros and cons of personal loans?

Like all credit options, there are pros and cons to taking out a personal loan. What is a benefit for one person may be a risk for another. So it’s important to do your own research and weigh up your options before committing.

Here are some of the factors to consider to help you work out if getting a personal loan is right for you:

Three potential benefits of a personal loan

In the right circumstances, personal loans can be advantageous because:

1. You can use them to consolidate existing debt

You could take out a personal loan to pay off some or all of your existing debts (including credit card debt and other loan products). If you can get one with a lower interest rate than you’re currently on, you could find having a single, smaller monthly repayment easier to manage than multiple fees and repayments at different times.

Related article: What is Debt Consolidation?

2. They can be flexible

Personal loans can be used for many purposes, such as consolidating debt, paying for weddings and holidays, and to pay off unexpected expenses, such as car repairs. They’re relatively easy to apply for and some can be approved quickly if you need fast access to cash.

Personal loans have a range of options. For example, you can have an unsecured or secured loan, with a fixed rate or a variable rate. They also come with a variety of term lengths (generally between one and 10 years) and some provide the option of weekly, fortnightly or monthly repayments.

While lenders may not lock you into how to use the money (except with a car loan), some may specify a list of approved uses for the loan. This is something to check before applying.

3. Some competitive interest rates may be lower than credit cards

Personal loans may come with lower interest rates than some credit cards. Furthermore, you may be able to apply to borrow a higher amount than on a credit card, if you’re in need of a higher limit and you’re confident you can make the increased repayments. But this usually depends on the type of loan being offered.

Keep in mind your credit score can influence your borrowing options, including how much money a lender approves you to borrow, plus the interest rate that applies.

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Three potential disadvantages of a personal loan

Let’s look at some of the potential disadvantages in taking out a personal loan:

1. Fees and interest rates could be high

Personal loans can come with high fees, interest rates and penalties that drive up the true cost of borrowing. While they can have lower interest rates than other options, such as some rewards credit cards, you may find that the interest rate is still high.

Further, borrowers with poor credit may end up paying higher interest rates than through a credit card. If you have savings or can wait until you have some built up, paying for your expenses in this way may be preferable.

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2. You’re locked into a contract

Personal loans lock you into a set payment period. Plus, depending on the type of loan you apply for, you may have to make a balloon payment (usually on car loans) or you could be penalised for paying off the balance of the loan before the end of the term.

Be sure to review all fees and penalties before applying, making a note of the comparison rate for a more accurate indication of the loan cost.

3. Personal loans increase your debt

Carefully consider if your reason for taking out a personal loan is worth the possible financial strain long term. Be mindful of overspending and taking on too much debt. When your debt becomes unmanageable, it can affect your ability to save money and pay other bills on time.

Related article: Responsible Borrowing: the Difference Between Good and Bad Debt

Will a personal loan help or hurt your credit score?

There are risks and benefits for how a personal loan could impact your credit score. Used responsibly, your credit score could improve if you consistently meet your repayments and practise healthy money habits. Additionally, using a personal loan for debt consolidation can reduce your number of open credit accounts and help your score.

On the other hand, while a personal loan may seem like a good short-term solution, if you haven’t properly budgeted to make on-time payments over the duration of the loan term, late payments and defaulting can harm your credit score. Also note that when applying for credit, lenders will look at all credit currently available to your name, which may reduce the amount of future credit you are eligible for.

Related article: How to Fix A Bad Credit Score

What about bad credit loans?

If you have a poor credit score, it may affect the loans or credit for which you can apply. Potentially, you may find you’re only eligible to apply for a bad credit loan, which is a type of personal loan for borrowers with bad credit. But be cautious before choosing this option. If your credit score is already low, applying for a new loan could impact it further, as each loan application you make is generally recorded on your credit report.

If you’re concerned about your credit score and your ability to meet loan repayments, carefully consider if this is the right option for you.

Related article: How to Check Your Credit Score And Why You Should

Is a personal loan is right for me?

If you’re unsure whether a personal loan is the right choice for you, you may want to consider talking to a financial advisor.

There are several free financial advice  options that may suit you. Your choice will depend on your life stage, the product or area you need help with and the urgency of your situation. Free financial advice options include:

• Moneytalks
• Face-to-face help from a financial advisor
• Sorted website
• Citizens Advice Bureau

Related article: Free Financial Advice in NZ: Where to Find it

About the reviewer of this page

This report was reviewed by Canstar Content Producer, Caitlin Bingham. Caitlin is an experienced writer whose passion for creativity led her to study communication and journalism. She began her career freelancing as a content writer, before joining the Canstar team.