In a perfect world, you’d never have to borrow money. You’d always save for things like car repairs, medical treatments or Caribbean vacations.
Of course, that’s not realistic. In fact, 46% of consumers don’t have even $400 saved for emergencies, according to a 2016 Federal Reserve report.
Meanwhile, the number of consumers with personal loans rose by 25% between 2014 and 2016 to 15.8 million, according to TransUnion. Online advertising for personal loans doubled during that period, presenting them as the go-to solution for debt consolidation, medical expenses, weddings, travel and home improvement.
For many borrowers, personal loans are cheaper than credit cards. Longer repayment terms and higher loan amounts make them appealing for bigger expenses, and budgeting for their fixed payments is easier.
Yet that doesn’t mean a loan is always a good idea. Here are three generally bad reasons to take out a loan — followed by two good ones.
When to avoid personal loans
Paying for medical expenses
One in four adults (26%) say medical costs have caused serious financial difficulties, according to a 2016 study by National Public Radio, the Robert Wood Johnson Foundation and the Harvard T.H. Chan School of Public Health. If that’s you, you may have considered a personal loan to cover your medical costs.
“I would never do this,” says Ed Vargo, a private wealth manager at Burning River Advisory Group in Westlake, Ohio. “I wouldn’t take out a personal loan to pay medical expenses.” His reason: Medical billing in the American health-care system is notoriously error-ridden. If you use a loan or credit card to pay for medical bills, “Good luck in getting [your money] back if they overcharge you.”
What to do instead: Vargo advises working directly with the medical provider’s billing office, which may be open to negotiating a lower bill or working out an affordable payment plan. “Doing it this way keeps the debt off your official credit report, and it typically doesn’t incur interest,” he says.
Unlike banks and credit unions, medical providers typically don’t report payments to credit agencies, so there likely would be no impact on your credit report — unless you failed to pay and the debt went to a collections agency. Even then, credit bureaus may ding your score less for unpaid medical debt than other types of debt.
financing a ‘dream’ wedding
Before going into debt for a $5,000 designer wedding gown or idyllic Hawaiian venue, consider that the average wedding cost $35,329 in 2016, according to The Knot. That’s near the $38,500 that buyers need for a down payment on a median-priced home in the U.S., according to Zillow.
Some online lenders advertise “wedding loans,” but there are no specific interest rates for weddings. As with any loan, borrowing for your special day can become a financial trap for you and your beloved.
Say you borrow $15,000 to fund your big day. Assuming you have excellent credit, generally a FICO score of 720 and up, the annual percentage rate on the loan might come out to 10.94%. If you have the loan for four years, you’ll still be on the hook for $387 a month in 2021.
Four years into your marriage, wouldn’t you rather that money be funding a down payment or baby expenses?
What to do instead: If you absolutely can’t trim your wedding budget and you have good credit, consider a 0% APR credit card for some wedding expenses. You’ll want to be sure you can pay off the balance within the promotional period before interest charges kick in. As a last resort, a smaller personal loan can sometimes prevent couples from overspending.
Advertisers tout “vacation loans,” but they’re really just loans with a tan. There’s nothing relaxing about borrowing for discretionary expenses when you’re paying for this year’s spring getaway multiple seasons ahead.
Say you borrow $5,000 to cover flights, lodging and meals for two. If your credit is good, generally 690 to 719, you might get a loan with an APR of 14.56% and payments of $241 a month for two years. If your credit score is below 620, your interest rate would be higher, maybe 28.64% APR, which means monthly payments of $276 for two years.
What to do instead: Save up and check your budget. Maybe spending just $400 and crashing on a friend’s couch in a distant city could be just as fun and make more financial sense.
When a personal loan might make sense
Debt can be a necessary part of life, and a loan used wisely can empower you. To avoid regrets, NerdWallet generally advises that you borrow only for necessities and get the least expensive debt you can. A credit card with a 0% introductory APR is a cheap way to borrow money, if you’re eligible and if you can pay off the balance before interest is charged. Credit unions may be a good option since their maximum rate on most personal loans is 18%.
consolidating ‘toxic’ debt
One debt move that can be helpful is getting a loan to consolidate “toxic” debt from payday loans or high-interest credit card balances. Depending on your credit score, a personal loan can replace several debts with a single payment at a lower interest rate.
For some, this can be a sensible way to get off the credit card merry-go-round. “You pay your credit card down a bit, then you want or need something and you go right back to the credit card and run it back up. Like yo-yo dieting, it’s a vicious circle,” Vargo says.
In contrast, a fixed-rate loan offers no opportunity to add debt and could help enforce financial discipline, he says.
If you use a loan, be careful not to run your credit card balances back up. “You may be saving some interest expense, but unless you address the underlying reason for the spending, you will be refinancing new debt into the existing debt in another year,” says Peter Creedon, chief executive officer of Crystal Brook Advisors of Mount Sinai, New York.
If you owe more than 50% of your gross income, you may be better off seeking out a credit counselor or bankruptcy attorney rather than a debt consolidation loan.
paying for essential home repairs
When your roof leaks after every storm, that’s when there’s no time to save for repairs, and borrowing may be a necessity. A loan might also make financial sense if you’re planning to update your kitchen or other area of your home that adds value to your property.
If you own a home, a home equity line of credit, or HELOC, will likely have a lower interest rate than a personal loan. A home equity loan is another option. Many financial planners advise tapping your home equity only for things that will increase its value, such as home improvements.
Creedon notes that you may get a tax deduction for interest paid on a home equity loan or line of credit. However, you’re using your home for collateral, so the lender could foreclose on your property if you default on your payments.
If you need to borrow money and can’t borrow against your home or get a 0% interest credit card, a personal loan may be a good option. Begin by comparing interest rates from banks, credit unions and online lenders to find a loan you can afford.