Avoid These Mistakes When Taking Out Personal Loans

WalletHub's 'Ask the Experts' asks Vice Dean, Nicole Thorne Jenkins, PHD, CPA, her expertise on personal loans. 

What is the biggest misconception people have about personal loans?

People often view personal loans as a way of getting out of debt or to get ahead. Personal loans are frequently taken out to consolidate debt – credit cards – or to fill a shortfall in income. However, covering/consolidating existing debt or filling an income shortfall without a robust plan to stop accumulating debt, cut expenses and/or increase income, with a personal loan may simply be delaying the inevitable financial crisis.

When does it make the most sense to consider a personal loan vs other forms of borrowing?

In general, personal loans should be used to move income from one period to another. For example, if you have an extra $200 per month in your spending, taking out a loan for $1,000 to make a purchase knowing that you will pay that amount off over the next 5 months is reasonable. However, borrowing money when you have no financial margin and no expectation of margin occurring in the near term allowing you to service the debt is not the best decision for most people.

Other forms of borrowing such as purchasing a real asset such as a house or a car are a bit different because these contracts are secured with the asset. The benefit of these arrangements is that if you are unable to adequately service the debt, you may be able to sell the asset and repay most or all the amount owed.

What is the biggest personal loan mistake to avoid?

Taking out a personal loan when you know upfront that you do not and will not have the ability to repay it.

What is the smallest amount of money you'd recommend taking out a personal loan for?

For most people, every time they use a credit card, they are effectively taking out a personal loan. If you can pay off the money you borrow when it comes due and you can afford and are willing to pay the related interest no amount is too small. 

What types of expenses would you recommend or not recommend using a personal loan for?

Personal loans should never be used to cover basic expenses if possible. These expenses should be covered from your normal recurring income. If your income is not adequate to cover your basic expenses, then either you need to increase your income or cut your costs. For most people, personal loans should be avoided unless you need to move future income into the present which implies that you can service the debt over its lifetime.

If I had to recommend when to take out a personal loan, it would be to fund college education a business venture, or a related investment. While risky, these activities generally result in an increase in future income which increases risk but at the same time may result in a significant return. There are many factors to consider in taking out loans to fund education such as earning potential, loan terms, etc. Similarly, when funding a business venture, the soundness of the business plan is critical.

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