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A personal loan is a flexible loan that you can use for just about any legal purpose. Whether you're seeking to pay for an unexpected medical bill, consolidate high-interest debt or fund a home renovation project, a personal loan can help you achieve your goals.
While a personal loan can be a versatile way to finance purchases, there are expenses you shouldn't fund with a loan. Here are five things you should not use a personal loan to purchase.
1. Paying College Tuition
Before you cover your college tuition with a personal loan, you should exhaust all funding options through scholarships, grants and federal student loans. Federal student loans are typically a better option than personal loans because:
- Federal student loans usually come with lower interest rates than personal loans. Undergraduate students can currently take out a federal student loan with a 4.99% fixed interest rate, whereas the average interest rate on a 24-month personal loan in the first quarter of 2022 was 9.41%, according to the Federal Reserve.
- You don't need a credit check for most federal student loans. The only federal student loans requiring a credit check are PLUS loans, which are designed for graduate or professional students and parents who take out student loans for their undergraduate dependents.
- You may qualify for a subsidized loan, depending on your financial need. In this case, the U.S. Department of Education covers your interest costs while you're in school at least half time, during your six-month grace period after leaving school and throughout any loan deferment periods.
- You may receive additional benefits. Federal student loans offer access to student loan forgiveness programs and income-driven repayment plans (IDRs). If you're facing short-term financial difficulty, you may qualify for deferment and forbearance options, which some, but not all, private student loan lenders also offer.
After you exhaust your federal student loan options, you might consider a private (nonfederal) student loan to cover a funding gap for your education. Generally, you can apply for private student loans through a bank, credit union, state agency or school.
Generally speaking, investing is not what a personal loan is used for. Even if you can generate a substantial return on your investment, the interest rates you must pay will cut into or even negate your returns. And, the longer you pay on your loan, the more interest you'll pay—something to think about since personal loans typically have repayment terms between one and five years.
What will you do if your income changes, the market underperforms or another unfortunate circumstance arises? It's wise to have a backup plan to cover your loan payments in such cases, or even wiser to avoid taking out a personal loan for investing purposes.
3. Putting a Down Payment on a Home
Most mortgage lenders prohibit using a personal loan for a down payment, and it may not be possible regardless of the lender's rules. That's because taking out a personal loan could raise your debt-to-income (DTI) ratio. As its name implies, DTI is the amount of recurring monthly debt you have relative to your income.
As a rule, when mortgage lenders review your loan application, they typically like your DTI ratio to be lower than 43%, with some preferring that number to be below 36%. Taking out a personal loan could cause an uptick in your DTI or even push it over the lender's desired threshold, resulting in a denial of your mortgage application.
Additionally, taking on new debt in the form of a personal loan could throw up a red flag to the lender that you don't have the financial strength to purchase a home.
4. Starting a Business
You may qualify for a personal loan—from a few hundred dollars to $100,000—to launch your business, but it may not be the best idea.
Unfortunately, personal loans don't help you build business credit. Instead, your lender reports your payments to the credit bureaus in your name (not the business's). If you fail to repay the loan, your lender could attempt to collect from you personally, and potentially sue you.
If your goal is to establish business credit so you can apply for a business loan in the future, you might consider getting a business credit card. With good credit, you may be eligible for a 0% APR introductory offer, giving you a period to pay off your purchases interest-free. Remember, however, that once the introductory APR period is up, the interest rate returns to its standard rate, which could be 20% or higher.
5. Covering Basic Living Expenses
Is a personal loan a good idea when you're strapped for cash and need to pay bills? Not usually.
A personal loan may indeed be a viable option to help you address a temporary hardship if you have a solid plan for getting back on your feet financially and repaying the loan. But, you could create a more significant problem in the long run since you'll have to repay all the money you borrow plus interest.
If your income isn't usually enough to cover the bills, it may be time to re-examine your budget. Look for areas where you can cut costs, like cooking at home more, using coupons or canceling unused subscriptions. Also, try to identify opportunities to increase your income. For example, you might request a raise at work, offer to work overtime or start a side hustle.
These measures may not be appealing, but breaking the debt cycle is worth it.
What Can I Use a Personal Loan For?
We've seen some examples where a personal loan may not provide your best option. Conversely, here are a few common reasons to get a personal loan:
- Consolidating high-interest debt: If you have multiple high-interest credit accounts, a personal loan can help you combine all those debts into one loan, with one payment, usually with a lower interest rate.
- Paying emergency medical bills: A substantial medical bill can call for your entire annual deductible in one payment, even if you have outstanding health insurance. Personal loans can be a cost-effective way to manage a large medical bill, but see if your medical provider will offer a payment plan first. Some may do so without charging interest.
- Funding home improvement projects: A home equity loan or a home equity line of credit (HELOC) are options worth considering if you're looking for cash to pay for home repairs or a major renovation. However, if you're not comfortable using your home as collateral—as these loans require—a personal loan may provide the funds you need.
- Paying for your wedding: If you haven't quite saved up enough cash to fund your dream wedding, a personal loan could help you fill in the gaps. This is often a better choice than credit cards because you'll get a lower interest rate, saving you money long term.
Get Your Credit in Order Before Applying for a Personal Loan
Deciding whether a personal loan is a good option will often depend on the interest rate a lender offers you. Without knowing your credit score beforehand, it's hard to know whether you're eligible for a personal loan and what type of interest rate you can expect.
You can get an idea of where your credit stands at no charge with an Experian credit report and FICO® Score☉ . If your credit could be better, take some time to improve your credit by addressing harmful items on your credit report. As a general rule of thumb, the higher your credit score, the more likely you'll qualify for personal loans and other credit products with the most favorable rates.