The Personal Loan Rules Financial Experts Rarely Break
There are many reasons people may take out a personal loan, such as simplifying expensive debt or funding a project. However, an affordable-looking payment does not automatically make it a smart financial move.
Experts say borrowers should evaluate what the loan will accomplish. Here are the personal loan rules financial experts rarely break.
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Rule No. 1: Know What the Loan Will Improve
Before borrowing, identify the specific problem the personal loan will solve and whether taking on debt will create a measurable financial benefit, said Ethan Aiem, founder and CEO of Klendify.
"If it's not obvious, I don't think the loan should be granted,” he said.
Using a loan to address a specific temporary need may make sense, while borrowing to support an ongoing budget shortfall can turn debt into an ongoing problem. If the answer is simply "I need it this month," then Aiem would advise people to proceed with caution.
"Don't let debt become the answer to a question you are never prepared to ask," he added.
Rule No. 2: Calculate the Total Cost, Not Just the Monthly Payment
Borrowers need to know that there are more costs involved with a personal loan beyond the monthly payment.
Heath Squier, CTO of Equity Edge Lending, said he would not break the rule of calculating total repayment and post-loan monthly budget before comparing lenders.
“A lower payment can hide a longer term, an origination fee or a much higher total cost," he said.
A simple way to figure this out is to write down the net proceeds after fees, annual percentage rate (APR), monthly payment, total interest, payoff date and any prepayment penalty, he explained.
Aiem offered a simple way to evaluate the trade-off: “If I borrow $10,000 and pay back $13,000, I want to have a good reason why the $10,000 was worth more than the additional $3,000.”
Rule No. 3: Base Affordability on Your Real Budget
A lender’s approval amount is a ceiling, not a recommendation.
“Never begin with the highest loan payment a lender claims you are qualified for,” Aiem said. Instead, use your true monthly cash flow, after accounting for housing, essentials, present debts, taxes and a modest savings amount.
Borrowers can “stress test” the payment by asking, “Could I still pay it if I earned less or had to cover an unexpected $1,000 expense? If the answer is no, then the loan is too big.
As Squier put it, loan approval tells you what you can borrow, it doesn't tell you what you should borrow.”
Rule No. 4: Make Sure Debt Consolidation Solves the Problem
A personal loan can be strategic when it replaces more expensive debt with a fixed payoff date or funds a necessary one-time expense, Squier said. However, consolidation only works if the interest and fee savings are worthwhile and the borrower does not rebuild balances on the paid-off cards.
“If the new loan is lower cost overall and the borrower doesn't begin to pay down the old balances again, it does save money,” Aiem said. In other words, if you are transferring $15,000 of credit card debt at 25% into a loan that is a great deal less expensive that can make sense.
But if you are going to combine those cards and then make additional charges on them again, you've turned one problem into two.
Rule No. 5: Don’t Use a Personal Loan To Stretch Into a Home
Ryan Thomson, an assumable mortgage specialist at The Assumable Guy, said, "One rule I never break: I don't let a client take out a personal loan to cover a down payment on a home.”
A $20,000 personal loan at 12% adds roughly $444 a month to their obligations, he explained. Using a high-interest personal loan for a down payment can increase a homebuyer’s debt-to-income (DTI) ratio, potentially jeopardize mortgage approval and leave them managing two significant payments.
“The rule underneath the rule -- never borrow short-term high-interest money to fund long-term low-margin assets. The interest rate math works against you in both directions,” Thomson said.
The best personal loan is not necessarily the one with the lowest advertised rate or payment. It is the one that solves a defined problem at a reasonable total cost without making the rest of the borrower’s financial life less stable.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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