The pros and cons of personal loans

How does a personal loan work?

A personal loan allows you to borrow money to pay for something or to consolidate your debt. As soon as you receive the lump sum amount, you begin repaying it over the agreed payment period, called a term, including interest and fees.

Personal loans can be beneficial when you need help getting on top of big or unexpected expenses if you don’t have the savings to fund it, but keep in mind they need to be paid back along with interest and fees.

Personal loans are just one option for borrowing money, and come with both benefits and risks, depending on your specific needs and circumstances.

What are the pros and cons of personal loans?

Like all credit options, there are pros and cons to taking out a personal loan. What is a benefit for one person may be a risk for another. So it’s important to do your own research and weigh up your options before committing.

Here are some of the factors to consider to help you work out if getting a personal loan is right for you:

Three potential pros of a personal loan

In the right circumstances, personal loans can be advantageous because:

1. You can use them to consolidate existing debt

You could take out a personal loan to pay off some or all of your existing debts (including credit card debt and other loan products). If you can get one with a lower interest rate than you’re currently on, you could find having a single, smaller monthly repayment easier to manage than multiple fees and repayments at different times.

If you’re comparing personal loans, Canstar’s comparison tables could be a good place to start. Canstar also assesses and ranks personal loans each year as part of our Personal and Car Loan Star Ratings. Check out which loans have received a 5-Star Rating.

2. They can be flexible

Personal loans can be used for many purposes, such as consolidating debt, paying for weddings and holidays, and to pay off unexpected expenses, such as car repairs. They’re relatively easy to apply for and some can be approved quickly if you need fast access to cash.

Personal loans have a range of options. For example, you can have an unsecured or secured loan, with a fixed rate or a variable rate. They also come with a variety of term lengths (generally between one and 10 years) and some provide the option of weekly, fortnightly or monthly repayments. While lenders may not lock you into how to use the money (except with a car loan), some may specify a list of approved uses for the loan. This is something to check before applying.

A word of caution – if you’re in need of fast access to a small amount of money, you may be tempted to take out a ‘fast’ personal loan. While these loans can be more easily accessible, they often have shorter repayment terms and very high fees and/or high interest rates.

3. Some competitive interest rates may be lower than credit cards

Personal loans may come with lower interest rates than some credit cards. Further, you may be able to apply to borrow a higher amount than on a credit card, if you’re in need of a higher limit and you’re confident you can make the increased repayments. But this usually depends on the type of loan being offered.

Keep in mind your credit score can influence your borrowing options, including how much money a lender approves you to borrow, plus the interest rate that applies.

A personal loan can still be an expensive way to cover the cost of a purchase. In particular, bad credit loans and payday loans or short-term loans can be very expensive overall. While lenders typically can’t charge interest on payday loans, The Australian Government’s website Moneysmart warns they can still charge “a lot” in fees, such as an establishment fee, monthly account keeping fee, default fees and charges and enforcement expenses. The Financial Rights Legal Centre goes as far as to recommend against taking out a payday loan.

In the table below, you can see the average, minimum and maximum interest rates, application fees and monthly fees for personal loans (unsecured variable personal loans of $10,000 being repaid over five years) and minimum and maximum interest rates, application fees and annual fees for personal credit cards on Canstar’s database.

Costs of personal loans versus credit cards

Personal loans

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Source: www.canstar.com.au – 28/02/2024. Based on unsecured personal loans on Canstar’s database available for a $10,000 loan and 5 year loan term. Where rate range applies the mid rate is used. Min and average fees based on loans charging fees.

Rewards credit cards

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Source: www.canstar.com.au – 28/02/2024. Based on personal credit cards on Canstar’s database, excluding interest-free cards. Min and average fees based on cards charging fees.

Low rate credit cards

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Source: www.canstar.com.au – 28/02/2024. Based on personal credit cards on Canstar’s database, excluding interest-free cards. Low rate credit cards include available credit cards with an interest rate of less than 12%. Min and average fees based on cards charging fees.

Three potential disadvantages of a personal loan

Let’s look at some of the potential disadvantages in taking out a personal loan:

1. Fees and interest rates could be high

Personal loans can come with high fees, interest rates and penalties that drive up the true cost of borrowing. While they can have lower interest rates than other options, such as some rewards credit cards, you may find that the interest rate is still high.

Further, borrowers with poor credit may end up paying higher interest rates than through a credit card (we explain how below). If you have savings or can wait until you have some built up, paying for your expenses in this way may be preferable.

2. You’re locked into a contract

Personal loans lock you into a set payment period. Plus, depending on the type of loan you apply for, you may have to make a balloon payment (usually on car loans) or you could be penalised for paying off the balance of the loan before the end of the term.

Be sure to review all fees and penalties before applying, making a note of the comparison rate for a more accurate indication of the loan cost.

3. Personal loans increase your debt

Carefully consider if your reason for taking out a personal loan is worth the possible financial strain long term. Be mindful of overspending and taking on too much debt. When your debt becomes unmanageable, it can affect your ability to save money and pay other bills on time.

Will a personal loan help or hurt your credit score?

There are risks and benefits for how a personal loan could impact your credit score. Used responsibly, your credit score could improve if you consistently meet your repayments and practise healthy money habits. Additionally, using a personal loan for debt consolidation can reduce your number of open credit accounts and help your score.

On the other hand, while a personal loan may seem like a good short-term solution, if you haven’t properly budgeted to make on-time payments over the duration of the loan term, late payments and defaulting can harm your credit score. Also note that when applying for credit, lenders will look at all credit currently available to your name, which may reduce the amount of future credit you are eligible for.

What about bad credit loans?

According to Moneysmart, if you have a poor credit score, it may affect the loans or credit for which you can apply. Potentially, you may find you’re only eligible to apply for a bad credit loan, which is a type of personal loan for borrowers with bad credit. But be cautious before choosing this option. If your credit score is already low, applying for a new loan could impact it further, as each loan application you make is generally recorded on your credit report.

If you’re concerned about your credit score and your ability to meet loan repayments, carefully consider if this is the right option for you.

What are my options if I’m unsure whether a personal loan is right for me?

If you are experiencing financial difficulty or receive Centrelink payments, you may have other borrowing options, such as the Pension Loans Scheme or No Interest Loan Scheme (NILS) if you meet eligibility requirements. If you are considering a short-term personal loan or payday loan, keep in mind there are many risks and potentially very high costs to consider.

Free financial advice is available from a financial counsellor via the National Debt Helpline (NDH), which you can contact on 1800 007 007. The NDH helps consumers find individual counsellors and organisations in their area. It can also provide information and resources on what your rights are if you are experiencing financial hardship.

Cover image source: Worawee Meepian/Shutterstock.com
This is an update of an article originally written by Kelly Stone.