A personal loan is money borrowed from a lender that a borrower is obligated to pay back—typically in fixed monthly installments—until the debt is paid off. Personal loans are nothing new. In fact, ancient Mesopotamia is credited with establishing the first large-scale system of credit and loans.
But somewhere along the personal loan timeline, a stigma developed. Personal loans can be (but are not always) seen as a mark of financial disgrace, used as a last resort by irresponsible spenders with bad credit. A 2020 survey indicated that 31% of Americans would prefer to go into debt than have to ask someone for a loan. (In fact, a whopping 15% of Americans carry a monthly credit card balance greater than $5,000, while 30% have a balance between $1,001 and $5000!)
While having an emergency fund to fall back on is always ideal, saving money is a privilege. Not everyone has the luxury of time to build up their rainy day fund. Even for those who do, financial hardships don’t play by the rules. They can hit hard and fast, wiping out a savings account in a fraction of the time it took to stash away.
As a strange silver lining of tough economic times, like global pandemics and record-breaking inflation, the stigma surrounding personal loans is disappearing.
There were a record 5.73 million loan originations in the USA in the fourth quarter of 2021. That’s 9.6% more than pre-pandemic numbers in 2019. In response to raised prices at the gas pump and the grocery checkout, Americans are turning to personal loans to cover the cost of basic necessities.
As loans become more ubiquitous, they also become more accepted by the general public. So there’s no better time to get smart about who we source them from.
If you’re considering taking out a personal loan, do you know who you can turn to? Here are three personal loan source options to consider both short-term and long-, along with their unique benefits and what to look out for.
- Traditional lenders like banks and credit unions offer both secured loans and unsecured personal loans for debt consolidation, business startups, and personal finance reasons.
- Loans through friends or family members are ideal for those with either little or poor credit history that can still make on-time payments.
- Borrowing from personal assets for large purchases avoids paying an origination fee or high interest rates, but comes with significant risk.
Personal Loan Option 1: Turn to Traditional Lenders
Over 56% of Americans with personal loans in a January 2021 survey had borrowed through a bank. While banks are the OGs of professional lending, credit unions and online lenders are popular traditional personal loan sources as well. Is what’s popular always the best option? Here’s what you need to know.
Pros of personal loans through a traditional lender
- Convenience: Traditional lenders offer a convenient application process. Whether a borrower wants to fill out an application in person, speak to someone over the phone, or handle the entire process virtually, there’s a traditional lender offering the experience they’re looking for.
- High lending power: Traditional lenders—banks especially—have higher lending power. When someone needs a large loan amount, such as debt consolidation loans, banks usually have deep enough pockets to meet their borrowing needs.
- Lower interest: Compared to credit cards and payday loans, installment loans through traditional lenders tend to offer borrowers lower APR (annual percentage yield, a measure of interest and other charges). As of August 2022, the average credit card APR was 21.40%, with penalty rates as high as 30.90% lurking behind potential late payments. In May of 2022, banks charged an average personal loan APR of 8.73%.
- Consistency: Fixed-rate personal loans are consistent. Borrowers can rest easy knowing that as long as it’s laid out in the contract, their loan’s terms and repayment plans will stay the same until the debt is paid back in full.
Cons of personal loans through a traditional lender
- Strict criteria: Financial institutions, including banks, credit unions, and online lenders, all tend to have strict criteria for borrowers. An applicant’s creditworthiness also plays a large role in personal interest rates.
Also, the application process through a traditional lender can be long and drawn out, meaning that if you need cash today, you’re not going to feel that pit in your stomach ease up just yet. One exception to this rule is payday loans, where borrowers take out a short-term, high-cost loan from a lender. The cash is immediate but it must be paid back, as the name suggests, on the borrower’s next payday, along with fees that can equate to almost 400% APR!
- Credit hits: Applying for certain types of loans, like mortgages and auto loans, requires a hard inquiry, which can cause your credit score to take a temporary dip. A hard inquiry can lower your credit score by 5-10 points and it can take up to 12 months to recover from it.
Late payments can also damage your credit score. Once you miss a billing cycle, most lenders will report the account to the national credit bureaus.
- Immediate payments: Speaking of payments, they tend to start right away with a traditional loan. If you’re already stretching every penny you have and planning on using the loan to tackle bills you’re already behind on, adding another payment to the monthly roster might be a financial hit you just can’t take.
When is a traditional route the right choice for a personal loan?
Traditional lenders are a tried and tested personal borrowing option. With a good credit score, working with a traditional lender can be an enjoyable loan experience. But if your credit is struggling or the idea of taking on another monthly payment sounds impossible, a traditional lender may not be the right option for you.
Personal Loan Option 2: Turn to Friends and Family
It may take some gumption, but turning to friends and family for a personal loan is a popular avenue for borrowers. There’s plenty of etiquette to keep in mind when choosing this route. Knowing the pros and cons of personal loans from the people closest to you can help.
Pros of personal loans through friends and family
- Less strenuous application process: When turning to a friend or family member for a loan, the application process is reduced down to a candid—yet serious—conversation. Aunt Sally isn’t likely to run a credit report, check your debt-to-income ratio, or require any application fees. She is likely to ask what led to your need to borrow, what your plans are for the cash, and how you plan on paying her back.
- Fast cash: With traditional banks and credit unions, it can take several days to receive funding. When borrowing from someone you know, it’s sometimes a matter of minutes before cash is either in hand or en route to your bank account after coming to an agreement.
- Delayed payments: A friend or family member may be more likely to agree to a delayed payment window for a personal loan. If you’re training for a new job and taking out a loan to get you through until your first paycheck, being able to delay payments until your income is steady is a huge benefit. A traditional lender is unlikely to delay the opening of the repayment window.
- Unique terms: Repayment terms for a personal loan through friends and family can be unique. For example, Uncle Joe may be fine with loaning you cash for your new business. He may also be okay with waiting for repayment until you start turning a profit or asking for a dollar amount or percentage per sale until the debt is repaid. This is another scenario unlikely to play out with a traditional lender.
Cons of personal loans through friends and family
- Awwwkward: Asking a friend or family member can be awkward, embarrassing, and even downright painful for some. It’s a scenario that can make both parties feel uneasy. A traditional lender has likely given out countless loans, and you don’t have the same track record with Grandma. Coming up with an effective and efficient process for determining, agreeing on, and executing terms for a personal loan with a family member is critical for comfort.
- Sudden changes: A traditional lender follows a repayment schedule to a T, making it simple to budget and keep on track with a predictable payment amount. Some financial institutions even encourage you to stick strictly to a repayment schedule by including a prepayment penalty. But if a friend or family member suddenly finds themselves in their own financial bind after agreeing to a loan, they might turn around and request you pay the money back faster than originally agreed. Coming up with a lump sum can leave you looking for yet another loan.
- Burned bridges: Sure, your credit may not take a hit when you default on a personal loan with someone you love. But that doesn’t mean you walk away scot-free. Failure to pay back a personal loan can ruin priceless relationships, and this worst-case scenario may be more common than you think. According to a 2019 survey, more than a third of respondents who had lent money to a friend or family member hadn’t been paid back.
When is a friend or family member the best choice for a personal loan?
Loans between family members and friends are ideal for borrowers with little, no, or even bad credit. They’re also great for those who want to borrow money without worrying about large upfront fees or higher interest rates. When a loan is discussed, negotiated, and documented with a proper promissory note, it’s more likely to succeed. Using a platform like Pigeon is one way family and friends can facilitate personal loans with ease and confidence.
Personal Loan Option 3 - Turn to Yourself
Sometimes, the answer to finding the right personal loan lies within.…your own financial assets. If you’re taking advantage of a 401(k) through your employer or own your own home, funds to get you through a rough patch may be closer than you think.
Pros of personal loans through personal assets
- Simple to access: Dipping into a 401(k) for extra holiday shopping money or to handle an emergency situation is common. According to Vanguard’s 2022 report, How America Saves, roughly 13% of 401(k) participants had an outstanding loan. What makes them so appealing is that there’s no loan application or minimum credit score required and the money doesn’t count as debt on your credit report.
- Lower interest rates: A home equity loan (HELOC) allows you to borrow against the equity you have in your home. Many turn to them for home improvements but a home equity line of credit can also be used to tackle credit card debt, medical bills, or pay off high-interest student loans. The current average home equity rate is 5.96%, making it a much more competitive interest rate (lower) than credit cards or even bank loans. Home equity loans also offer predictable payments that can be stretched out in a repayment period as long as 30 years.
Cons of personal loans through personal assets
- High risks: Funds in a 401(k) account are protected from bankruptcy. Taking cash out of a protected account can be risky. If your current financial situation holds a high risk of bankruptcy, leaving 401(k) funds intact and protected is recommended.
- Drawn-out process: It can take several weeks to receive funds from a 401(k) loan and the entire home equity loan process can take up to two months. If you’re in a hurry for cash, a personal asset loan might not be the best option.
- Serious penalties: Not paying back a loan taken from a 401(k) or a home equity loan can have disastrous consequences. Defaulting on a 401(k) loan can result in additional income taxes and potential early withdrawal penalties. It can also leave you underfunded and unprepared for retirement. Failure to repay a home equity loan could lead to foreclosure.
When are personal assets the best choice for a personal loan?
Borrowing from a 401(k) or taking out a home equity loan are acts best left to those with some financial stability. Switching jobs or suddenly finding yourself unable to make a payment can have catastrophic consequences other types of loans don’t carry.
Weighing the Pros and Cons of Personal Loans
The good news is that there’s more than one source to choose from when it comes to finding a personal loan. Whether you turn to a traditional lender, a family member or friend, or even yourself will depend on your unique circumstances. Just remember:
“Every time you borrow money, you’re borrowing against your future self.” - Nathan W. Morris
In other words, loans are a temporary solution that should be used sparingly. But when used with a smart end goal in mind, personal loans can be a stepping stone to a better financial future 🙌.
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