10 Things You Need to Know Before Taking Out a Personal Loan

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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.

Here's what you should consider before getting a personal loan.

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)

5. Personal loans can be a lifesaver when you need cash quickly

When an urgent financial need rears its head — a leaky roof, an emergency medical bill, or, heaven forbid, an unexpected funeral — many people turn to credit cards or payday lenders for help. These lenders can be punishingly expensive, but they may seem attractive because in such situations you just don't have time to sit down and apply for a home equity line of credit or look at refinancing your mortgage.

You can get the funds from a personal loan within two weeks of applying online, making it just a little slower than the alternatives and potentially much more affordable. (See also: 5 Times Personal Loans May Be Better Than Credit Cards)

6. Personal loans can save you a lot on debt you already have

One of the most common uses for a personal loan is to consolidate existing debt, like credit card balances, student loans, and car loans. You may be able to get a lower interest rate than you were paying on your other debts, and you also have the organizational benefit of having only one bill to pay each month. However, when transferring one kind of loan to another, you should ...

7. … Be aware of what you may be giving up

Some marketplace lenders heavily market the idea of refinancing student loan debt into personal loans. But before you make a decision like that, you should compare your old loan and new loan carefully, the Consumer Financial Protection Bureau warned in a 2016 release.

"[I]n some cases consumers could lose important loan-specific protections by refinancing an existing debt. Specifically, consumers should know that they may sign away certain federal benefits, such as income-driven repayment for federal student loans or service member benefits," the CFPB said. (See also: 8 Valuable Rights You Might Lose When You Refinance Student Loans)

8. You might be better off with a different type of loan

If you're trying to get a better rate on credit card debt while you pay it off, before you commit to a personal loan, shop around to see what else is out there. You may be able to transfer your balance to a card with a promotional 0 percent interest rate. Another potentially better deal could be taking money out of your retirement account for a short time, especially if you have a Roth IRA. Just make sure to pay back whatever you borrow.

9. Watch out for fees and extras

Some lenders will try to throw in an insurance policy or other extra expenses as you close the loan. You may or may not want an insurance policy to make sure that your survivors aren't stuck with your loan if tragedy strikes, but that's a separate financial decision that you should undertake with research, not just because you're under the impression that it's required for your loan. (If the lender says it is, walk away.)

Also, ask the lender if they use the "pre-compute" method to calculate interest, or if they have prepayment penalties — you should avoid these, because both will punish you if you're able to pay the loan back ahead of schedule.

10. Never get a personal loan to fund certain expenses

One of the nice things about a personal loan is that unlike a car loan or mortgage, you don't have to justify your purchase to the lender. However, there are things you should know better than to borrow for — whether it's with a credit card, a home equity line of credit, or a personal loan.

Don't take out a personal loan to buy an engagement ring; why would you want to start out your relationship with a pile of debt? While some lenders may advertise a personal loan as a "travel loan," that's another bad idea; once the vacation is over, you have nothing that you could sell to pay off the loan if you need to. Do I need to tell you that you shouldn't take out a personal loan for gambling money? I didn't think so. (See also: Never Borrow Money for These 5 Buys)

A more complex question is whether it's OK to use a personal loan for a down payment on a home. The whole point of requiring a buyer to make a down payment is to show that they can afford the home and to help them feel invested in the purchase. So your mortgage lender may not like it if you try to fund the down payment with a personal loan. At the very least, with this method, you'll need to get the loan several months in advance of the purchase. But even then, proceed with caution; adding debt in the form of a personal loan could affect your chances of getting approved for the mortgage at all. (See also: 5 Money Moves That Will Ruin Your Mortgage Application)

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