Every kind of borrowing comes with costs. At the very least, borrowers are charged interest (known as APR) for taking out a loan or carrying a credit card balance (the exception being 0% interest credit cards, but usually these require you to repay your balance within a certain length of time).
But beyond interest, you may also encounter administrative fees, late payment fees or even get hit with penalties for paying off debt earlier than you agreed to.
We know...ouch. That's not to say you can't borrow affordably — but you need to make sure to do your research and come up with a plan.
Personal loans are a form of installment credit, which means you'll pay interest on the money you borrow until the balance hits $0. If you take out a personal loan, you want to make sure you're borrowing at the most affordable rate you can qualify for, especially if you're also juggling other financial priorities, such as saving for retirement.
The average personal loan APR is 9.34%, according to the Fed's most recent data. The average credit card APR is nearly double that at 16.43%. In some cases, it might be smarter to take out a personal loan rather than rack up a big balance on your credit card, but not always. And while it sounds really nice to be debt free, the reality is, most of us are paying off some kind of debt. But how do you know if you're getting the best rate?
Avoid loans with APRs higher than 10% (if possible)
According to Rachel Sanborn Lawrence, advisory services director and certified financial planner at Ellevest, you should feel OK about taking on purposeful debt that's below 10% APR, and even better if it's below 5% APR.
At such low rates, Sanborn Lawrence argues that you can breathe easy knowing you can make up for those interest fees in other areas.
"It's this concept in finance called arbitrage," Sanborn Lawrence tells Select. "That is, effectively, borrowing money at a lower rate than you're able to make on that money."
It may sound fancy, but arbitrage is simple: If you had a $5,000 loan and were paying 4% interest on it for two years, but also had $5,000 invested in the stock market that earned 8% annually, you would be earning more on your investments than you're paying in interest.
"You're going to end up net positive," explains Sanborn Lawrence.
Like everything money-related, this comes with a little bit of risk. Borrowing and investing is always a gamble since there's no guarantee the stock market will perform the way we think it should.
However, it's a calculated risk based on historical data: "We say 5% to 10% because that is the historic average rate of return of investments," says Sanborn Lawrence.
The S&P 500 index, a composite index that's used as a benchmark for American stock performance, has historically yielded gains of 10% to 11% on average since its inception in the 1920s.
But while Sanborn Lawrence's advice is rooted in fact, she acknowledges that it's not one-size-fits-all: "It does depend on, of course, how aggressively you invest," she says. If your portfolio is more conservative, you should think carefully before take out a loan that has an APR over 5%.
Shop around for the best offer
Your personal loan APR will be decided based on your credit score, credit history and income, as well as other factors like the loan's size and term. Some of these factors you can control; some might be out of your hands.
As you begin to search for a personal loan, it can be helpful to compare several different offers to find the best interest rate and payment terms for your needs.
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While you might not be able to avoid paying an APR above 5%, you can find personal loan options that don't charge origination fees or early payoff penalties. Select evaluated dozens of lenders and found five minimal-fee options that offer a variety of term lengths (from six months to 12 years) and APRs.
LightStream, the online lending arm of Truist Bank, is our top choice for personal loans with flexible terms for people with good credit or higher. You can get a LightStream loan to buy a new car, remodel the bathroom, consolidate debt, cover medical expenses or pay for a wedding.
LightStream loans aren't available for education or small business funding, but SoFi offers both personal loans and loans for refinancing student debt.
Bottom line
History tells us that taking out loans at 5% to 10% APR might not be a big deal if you can handle the financial obligation. However, the best interest rate is always 0%. If you have a good credit score and haven't applied for too many credit products over the last year, check out 0% APR credit cards to finance your next major purchase rather than applying for a loan.
If you ultimately decide you need a personal loan, consider both how much the monthly payment will cost you in addition to how much interest you're going to pay over time.
Taking out a loan is a balancing act between short-term needs and long-term financial health. But with a little research (and a decent credit score), you'll be happy you took the time to consider your future self.
