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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 race 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 are a quick way to borrow money from a bank and other financial institutions—but you have to pay the money back (plus interest) over time.  

Sure, personal loans may seem like a great option when you’re in a tight spot and need some quick cash to tide you over. But like all debt, personal loans always cost you—often, more than just in your wallet.

Let’s dive into what a personal loan actually is (and what it’s not), the reasons people use them, and how you can cover those crazy emergency expenses without taking on the burden of debt.

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 even a new HVAC system—aka personal reasons.

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That doesn’t include borrowing $1,000 from your Uncle John 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 a better credit score because there’s no physical item the lender can take away if you don’t pay up. And to be honest, we aren’t fans of the ole credit score. Shocked? That’s okay. 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 take what’s now theirs.

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 to and from work getting repo’ed because you’re still paying for last year’s kitchen remodel. 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.

Just do the math: You’ll 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 buried 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 rate and tell yourself you’ll pay off the loan quickly, but that number can balloon—and fast.

It’s easier than you think to get stuck with a higher interest rate and monthly payments you can’t afford. This is what we call an old-fashioned bait and switch. And you’re the fish hanging on a line.

Installment Loans

An installment loan is a personal loan you pay back in fixed installments over time (usually once a month) until it’s paid in full. And don’t miss this: You have to pay back the original loan amount before you can borrow anything else. And even if you 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. Talk about making a hard situation even harder!

Personal Lines of Credit

Some lenders 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 don’t be mistaken: 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. This one gets us riled up. Why? Because these businesses prey on people who can’t pay their bills. And that’s just wrong. Technically, these are short-term loans that give you your paycheck in advance. That may sound hopeful when you’re in a financial wreck 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 (and keeping you stuck in the cycle of debt), 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 pay).

But you should never cosign a loan. Why? Because things get real messy real fast when you miss a payment. Those creditors will come after your sweet grandmother who cosigned the loan for you. Oh, and you should never cosign a loan for anyone else either! Not only could you get stuck with a loan that was never meant to be yours in the first place, but it’ll ruin the relationship before you can say “pay up.” Trust us, you don’t want to be on either side of this sticky situation.

Reasons People Take Out Personal Loans

Reason 1: They want to consolidate their debt.

Truth: A lower interest rate won’t get rid of your debt.

When faced with a 17% interest rate on your credit card and a whopping 25% interest rate on an auto loan, a 9% interest rate for a personal loan can be pretty tempting. But all you’re really doing is using new debt to pay off old debt (and extending your loan term). That just means you’ll be paying even more over time. Companies know that too—which is exactly why so many of them offer you consolidation loans.

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 won’t solve your problem.

Reason 2: They want to build up their credit.

Truth: You don’t need a credit score to be successful.  

In a world where people treat good credit like Willy Wonka’s golden ticket, it’s easy to believe you need to take out personal loans to build up your FICO score. But good credit is an oxymoron. You only get a good credit score by borrowing money—a lot of money.

Around here, we call it the “I love debt score.” Why? Because you take on a ton of debt and risk, just for the “privilege” of going into even more debt. The system is rigged!

Don’t worry, there’s good news: 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 . . . ever.

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

Truth: If you can’t afford it, don’t go into debt for it.

This is a good rule of thumb for any financial purchase. Whether you’re thinking of taking out a personal loan to cover that kitchen remodel or your overwhelming credit card bills . . .  don’t. Taking out debt to pay for things isn’t the way to go. Sure, it might be a quick fix for right now, but it will have you stuck in debt for years to come.

The best thing you can do for your financial future is get out of that buy-now-pay-later mindset and say no to those spending impulses. And if you’re considering a personal loan to cover an emergency, we get it. But borrowing money to pay for an emergency only escalates the stress and hardship of the situation. This is where an emergency fund comes into play. When you have money socked away just for emergencies, you won’t have to worry when the dishwasher breaks down or the basement floods. Why? Because you’ve already got it covered.

Should You Get a Personal Loan?

Absolutely not. Personal loans are just not worth the stress and financial burden they bring to you and your family. Period. 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, they only leave you stuck in more debt and financial stress when it’s all said and done.

Taking out a personal loan is like trying to stop your boat from sinking by scooping out water with a bucket full of holes. It’s a lot of work—that just gets you nowhere.

The weight of personal loans (plus interest) keeps you from making real progress with your money. If you’re too busy paying for the past, there’s no room to invest in your future. Who wants to spend the rest of their life dragging around debt? It’s time to say “no more” to personal loans so you can actually start winning with your money!

Alternatives to Taking Out a Personal Loan

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.

That’s why taking out a personal loan is more harmful than it is helpful. Use these alternatives to help you steer clear of taking on more debt when you’re in a bind:

Get on a budget.

budget tells your money where to go before you ever spend it. That way you can be confident your necessities are taken care of. No need to take out a personal loan when you’ve budgeted for your expenses. In fact, EveryDollar helps you create a zero-based budget (where your income minus expenses equals zero). This means you’ve given every single dollar a job to do . . . putting you back in the driver’s seat of your finances—where you belong. Doing a regular budget will give you the confidence you need to manage your money successfully.

Save up for what you want.

Good things come to those who wait . . . and save! Instead of taking out a personal loan every time you want something, what if you saved up for it instead? It will definitely require some planning and discipline to put money aside every single month. But saving up for the big things means you’re not going into debt for them. And you aren’t paying more in the long run because of all that interest.

Trust us, you’ll enjoy that family cruise or playground set for the kids way more knowing it’s already paid for (instead of making payments on them until they’re off to college). Ouch.

Build up an emergency fund.

Life happens. And sometimes it can get really expensive. The car breaks down, the roof needs to be replaced, the pipes burst . . . all things you can’t control. But you can control how you respond to those life emergencies. Instead of running to get a personal loan to take care of it, you need to build up an emergency fund. That’s where the Baby Steps come in. Step one? You guessed it: Save $1,000 for a starter emergency fund.

Sure, $1,000 doesn’t seem like much in the face of an emergency, but it does provide peace of mind when things hit the fan. As you continue following the Baby Steps, you’ll eventually grow that fund to three to six months of expenses. And it’s worth all the hard work it takes to get there. Nothing beats peace of mind (without debt of course)!

Get Serious About Paying Off Your Debt

Debt is a trickster. It reels you in only to hang on for dear life like a crusty old barnacle. But you don’t have to turn to personal loans and debt when things get tight. There’s a better way! You can be free of debt and start making real traction with your money. It starts with knocking out your debt—once and for all!

If you’re ready to take control of your money (without loans), it’s time to get on a plan. Financial Peace University (FPU) is the plan that will show you how to save for emergencies (so you never have to take out a personal loan again), pay off debt, and build wealth for your future. The best part? Accountability. You can choose to take this course with others learning how to win with money—just like you. And when you’ve got people cheering for you every step of the way, you won’t want to look back. Sign up for FPU and end the cycle of debt for good!

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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