Although borrowing money may seem like a good idea if you're strapped for cash, there are times when getting a loan may be a bad idea. While it's true a personal loan can be used for almost any reason, interest charges can add up, and your credit may take a hit if you miss payments.
With this in mind, here are five situations where taking out a loan may not be a good decision.
1. You Already Have a High Amount of Debt
Juggling multiple debts can put a strain on your finances and hurt your credit, especially if you already have a high amount of debt. The more money you put toward paying off a new loan means less money left over to cover your other monthly expenses. If you fall behind and are late making a payment, your credit can take a hit. You might also get stuck living paycheck to paycheck with little leftover for saving, buying a home or securing your retirement.
Besides that, when you apply for a loan, lenders look at your credit score and credit report, as well as your debt-to-income ratio (DTI), when deciding whether to approve your application. Your DTI compares your monthly income to your monthly debt. If you're already carrying a lot of debt, you may need to lower your DTI before applying to show lenders you can meet your financial obligations.
Most mortgage lenders want a DTI of less than 43% (but 36% or less is preferred). However, if your credit score is high enough, many personal and auto loans may not be as concerned about your DTI.
2. You Can't Afford the Payments
Falling behind in your monthly obligations can be stressful. It can also negatively impact your credit. If you're already struggling to afford your existing monthly payments, now is not the time to take on additional debt. While it's tempting to use a personal loan to help pay off high-interest debt such as credit cards, it still comes with the risk that your monthly payments will remain unaffordable.
In addition to the interest you'll pay on the loan, some loans may charge an origination fee and other fees, like a prepayment penalty if you pay off your loan early and late fees if your payments are overdue. Personal loans also have a fixed monthly payment that could be higher than the minimum required payment on your credit cards, which could add to your financial stress.
If you can't afford your existing payments, contact your lender to explain your situation and discuss payment options. They may be willing to work with you to offer a flexible repayment plan, a reduction in your interest rate or a loan extension.
3. There Is a Cheaper Alternative
Before you take out a new loan, it's important to understand the total cost of borrowing, not just what your monthly payment will be. Look at the loan APR, which is the annual cost of a loan, including interest and fees. When you're evaluating loan costs, consider alternatives that may be cheaper.
- Introductory 0% APR credit card: If you qualify for an intro 0% APR credit card and repay your balance before the introductory period ends, you could save money, and you may even improve your credit score. But making a late payment on your card may result in forfeiting your introductory APR period. And, if you don't pay off the balance before the intro period ends, you'll pay interest on the balance at the rate stated in your agreement.
- PAL loan: Another option is a loan from a credit union called a payday alternative loan or PAL loan. You must be a member for at least one month prior to applying, but interest rates are often significantly lower than other types of short-term loans, such as payday loans. Loan amounts range from about $200 to $1,000, with most repayment periods of one to six months. You'll likely pay an application fee of up to $20.
It also might be worth exploring a home equity loan or home equity line of credit (HELOC), or using your savings, as an alternative to taking out a loan. But remember, each of these options also come with risks to consider first.
4. Your Credit Needs Work
Making on-time payments every month on your loan can raise your credit score. If that's your goal and you have a solid repayment plan, taking out a loan may not be a bad idea. But, if your credit needs work, you may be considered a risky borrower and your lender may charge a higher interest rate than if your credit is good. Besides, higher interest rates generally mean higher monthly repayments, and higher payments may be more difficult to manage.
5. You're Using It for the Wrong Reasons
Taking out a loan and using it to fund your college education or start a business may have good long-term benefits. But getting a loan may not make financial sense in every case. If you're taking out a personal loan to meet your basic monthly living expenses, for instance, you may want to consider other options, such as reevaluating your budget, looking for ways to cut costs, increasing your income or seeking financial assistance.
The Bottom Line
When deciding if taking out a loan is a good or bad idea, it's best to understand the benefits, the drawbacks and the risks involved. It's also worthwhile to compare personal loans with Experian CreditMatch™ to see the best loans matched to your credit profile.
And, since lenders look at your credit to determine your eligibility, get your free credit report and score from Experian first. This can help you understand whether you might qualify for a loan and also allows you to check your credit accounts, current balances, payment history and total debt.