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The Personal Loan Explained

It’s the middle of summer, and your AC suddenly goes out. You don’t have a couple thousand dollars to get it fixed, but the temperature is rising, the kids are screaming, and you’re sweating from more than just the heat. So, you head down to your local credit union and borrow the money to cover the repair. And that’s when things get personal . . . in the form of a personal loan.

Personal loans may seem like a great option for when you’re in a tight spot and need some cash to tide you over. But, like all debt, personal loans always come at a cost. Let’s dive into what a personal loan actually is, the reasons people use them, and how you can cover those emergency expenses without taking on the burden of a personal loan.

What Is a Personal Loan?

A personal loan is a lump sum of money you can borrow for . . . well, almost anything. People take out personal loans for everything from paying for a wedding or building a swimming pool to buying a new washing machine or adopting a pet chinchilla—aka personal reasons.

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That doesn’t include borrowing $1,000 from your Uncle Bob to help you pay for Christmas presents or letting your roommate spot you for a couple months’ rent. You shouldn’t do either of those things (for a number of reasons), but that’s technically not a personal loan. Personal loans are made through an actual financial institution—like a bank, credit union or online lender. And just like there are different types of debt, there are also different types of personal loans out there. Let’s take a look at each so you can know exactly how they work—and why you don’t need one. Ever.

Types of Personal Loans

Unsecured Personal Loans

Most personal loans are unsecured, which means there’s no collateral (something to back the loan, like a car or house). Unsecured loans typically have higher interest rates and require better credit because there’s no physical item the lender can take away if you don’t pay up. But no matter how good your credit is, you’ll still have to pay interest on most personal loans. There’s always a price to pay for borrowing money.

Secured Personal Loans

Secured personal loans, on the other hand, have some sort of collateral to “secure” the loan, like a boat, jewelry or RV—just to name a few. But if you don’t pay on time, the repo man will come knocking to take your precious item away.

You could also take out a secured personal loan using your car as collateral. But that’s a dangerous move! You don’t want your main mode of transportation getting repossessed because you’re still paying for your kitchen remodel or a vacation you took months ago. Trust us, there’s nothing secure about secured loans.

Fixed-Rate Personal Loans

Most personal loans are fixed-rate, which means the interest rate and your monthly payment don’t change. But just because the payments are predictable, it doesn’t mean this is a good deal. Like we said before, you’re pretty much guaranteed to pay interest on a personal loan. So, you only need to do the math to see that you end up paying way more in the long run by taking out a loan than if you’d just paid with cash. Fixed-rate loans are just part of a fixed system to keep you in debt.

Variable-Rate Personal Loans

Also called adjustable-rate, variable-rate loans have interest rates that can change. You might be drawn in by the deceptively low interest and tell yourself that you’ll pay off the loan quickly, but that number can balloon fast. It’s easier than you think to get stuck with a higher interest rate and monthly payments you can’t afford. That, my friend, is called a bait and switch.

Installment Loans

If a personal loan is an installment loan, you pay it back in fixed installments over time (usually once a month) until it’s paid in full. It also means you have to pay back the original loan amount before you can borrow anything else. But even if you can pay on schedule, you’re still paying interest. Plus, if you suddenly fall behind because you lost your job, had an emergency, or overspent one month, you’re looking at even more interest added to your tab.

Personal Lines of Credit

Some lenders may offer personal lines of credit. Instead of getting the full amount up front, you take out small amounts of the loan as needed. You still have a preapproved credit limit and you still have to repay what you borrow in monthly payments. But this isn’t the same as a credit card. With personal lines of credit, you’re paying interest on the loan—even if you pay on time. This kind of loan is super tricky because it makes you think you’re managing your debt, when really, it’s managing you.

Payday Loans

Payday loans. Ugh. Technically, these are short-term loans that give you your paycheck in advance. That may sound nice when you’re in a pickle and need some money to cover your bills. But payday loans are straight-up scams! They have insane interest rates (391% on average!) and usually target people in lower-income areas by not doing credit checks.1 Once you get involved with payday loans, it’s extremely hard to get out. So, unless you like people stealing from you, steer clear of those blood-sucking payday lenders!

Cosigned Loans

If a lender decides you don’t have a good enough income or credit history to get approved for a personal loan, they can require you to have a cosigner—someone with better credit who can take on the loan if you can’t. But you should never cosign a loan. Why? Because things get messy real quick when you miss a payment and the creditors come after your grandmother who cosigned for you. Trust us, you don’t want to be on either side of this tense situation.

Reasons People Take Out Personal Loans

Reason 1: I want to consolidate my debt.

Truth: A lower interest rate won’t solve your problem.

When faced with either a 17% interest rate on your credit card or a 9% interest rate for a personal loan, we get why you might want to take out a loan to cover your unpaid credit card balance. But this is like a dog chasing its tail. All you’re doing is using debt to pay off debt and extending your loan term—which means you’ll actually pay more over time.

Here’s the deal: A lower interest rate doesn’t get you out of debt—you do. Personal finance is 80% behavior and only 20% head knowledge. That means unless you’re willing to do what it takes to pay off your debt, taking out a personal loan to consolidate your debt isn’t going to solve your problem.

Reason 2: I want to build my credit.

Truth: A credit score doesn’t have to rule your life.  

In a world where people treat good credit like Willy Wonka’s golden ticket, it’s easy to believe that you need to take out personal loans to build up your FICO score. But good credit is an oxymoron. You only get a good score by borrowing money—a lot. You take on a ton of debt and risk, just to get the “privilege” of going into even more debt. It’s a rigged system. But the good news is, you don’t have to play. Believe it or not, you can survive (and thrive!) without a credit score. And it starts with not borrowing any more money.

Reason 3: I don’t have the money to pay up front.

Truth: If you can’t afford it, you shouldn’t buy it.

Yeah, we know that may sound harsh. But if you don’t have the money to drop on a kitchen remodel, an over-the-top wedding venue or a family vacation, that doesn’t give you permission to go into debt for it. Taking out personal loans may seem like a quick fix, but you don’t want to spend years paying for the past like everyone else.

The best thing you can do for your financial future is get out of the buy-now-pay-later mindset and learn how to say no to your spending impulse. (But don’t worry—we’ve got some better ways you can save up for that Disney trip or pet chinchilla that don’t involve personal loans.)

Is Taking Out a Personal Loan Worth It?

No. Nope. Absolutely not. In case you haven’t realized it by now, personal loans are totally not worth the stress and financial burden. We know it may seem like taking out a loan will help you get ahead or even just offer some relief in the middle of a crisis. But trust us, loans only leave you several steps behind where you started. Taking out a loan is like trying to bail yourself out of a sinking boat with a bucket full of holes. It’s a lot of work to get absolutely nowhere.

The weight of personal loans (plus the interest that’s automatically tacked on) keeps you from making real progress with your money. You’re too busy paying for the past to invest for your future. Do you really want to spend the rest of your life dragging around debt? Yeah, we didn’t think so. It’s time to say “no more” to loans so you can be free. Free to do what? Whatever the heck you want!

Alternatives to Taking Out a Personal Loan

Get on a budget.

It’s one thing to say no to big expenses (like vacations), but what if you rely on personal loans to pay bills and buy food? Even if you don’t have a ton of money coming in every month, how you manage the money you do have makes all the difference. A budget helps you take control of your money by telling your money where to go before you spend it. When you’ve done the math ahead of time (or better yet, let EveryDollar do the math for you), you can feel confident that the basics are taken care of and you don’t need to take out a loan to put food on the table. And budgeting doesn’t have to be complicated for you to reap the benefits.

Save up for what you want.

Good things come to those who wait . . . and save! Instead of jumping on the personal loan train every time you want something, what if you took time to save for it instead? Yeah, it will require some planning and discipline to put money aside every month. But saving up for the big things means less stress and guilt than going into debt for them. Trust us, you’ll enjoy that family cruise or playground set for the kids way more knowing it’s already paid for and you won’t be making payments until those kids are in college.

Get serious about paying off your debt.

Is debt weighing you down? Do you feel like the only way to pay for things is to take out loans? Hey, we see you. But it doesn’t have to stay that way. You can get off the hamster wheel and start making real traction with your money. And it starts with knocking out your debt once and for all!

If you’re ready to live a life where debt doesn’t hold you back, Financial Peace University (FPU) will show you how. This course has helped millions of people, just like you, take control of their money for good. You’ll learn how to pay for things without loans, pay off all your debt (yes, we said all), and build wealth for your future. Go ahead and try FPU today for free! The cycle of loans ends here.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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