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An emergency fund is an important element of a healthy financial plan and can help you avoid debt and provide peace of mind in the event of a rainy day. That said, it can take several months or even years to establish a strong emergency fund, leaving you vulnerable to unexpected expenses in the meantime.
Taking out a personal loan and stashing the proceeds in your savings account can give you a head start on your savings. But taking on debt before you actually need it can negatively impact you in other ways and put your financial well-being at risk. Here's what to consider before you try it.
What Can Personal Loans Be Used For?
Personal loans are among the most versatile forms of credit available. Offered by traditional banks, credit unions and online lenders, personal loans can be used for just about anything you want, including:
- Financial emergencies
- Debt consolidation
- Vehicle or home repairs
- Home renovation projects
- Weddings
- Moving expenses
- Medical bills
- Funeral costs
- Vacations
- Business startup costs
Depending on the lender, however, there may be some restrictions. Commonly prohibited uses include educational expenses, investments and illegal activities. Some lenders may also ban business expenses.
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Pros and Cons of Using a Personal Loan as an Emergency Fund
If you've recently drained your emergency fund or you're just getting started with building one, there are both advantages and disadvantages to using a personal loan to build your savings. Here's what to consider.
Pros
- Can give you peace of mind: While you need to make a monthly payment on your loan, having a sizable emergency savings balance can give you peace of mind in the face of potential expenses that might come up.
- Can be relatively inexpensive with great credit: Some online lenders offer interest rates as low as 6%, which can help keep your interest charges low. If you can afford the monthly payment and you're willing to pay a little interest in exchange for peace of mind, it could be a good fit.
- Gives you access to money when you need it: If you wait until you're in the midst of a financial emergency to apply for a personal loan or a 0% intro APR credit card, you might not get the funds you need when you need them.
Cons
- Can be expensive: If you don't have excellent credit, it can be difficult to qualify for a low interest rate, making it an expensive endeavor. The more you borrow, the more expensive the interest will be.
- Monthly payment can be high: Depending on how much you borrow, it may be difficult to keep up with the monthly payments. You could reduce your payment by opting for a longer repayment term, but that will result in more total interest charges.
- It may not be necessary: It's generally best to avoid going into debt unless you absolutely need to, especially if it's expensive debt.
Alternatives to Using a Personal Loan as an Emergency Fund
While it may be tempting to use a personal loan to build your emergency fund, there are few situations where it might make sense. Before you go down that path, consider these alternatives:
- Create a budget. Review your income and expenses from the past few months, then categorize your expenses to understand where your money is going. At that point you can determine how you want to spend your money in a way to prioritize building your emergency fund.
- Pay yourself first. Instead of saving whatever is left over at the end of each month, include your savings in your budget and set up automatic transfers from your checking account to your savings account when you get paid to ensure it happens.
- Use credit cards. If you experience a financial emergency when you're low on cash, credit cards may not be ideal. But if it's a relatively small emergency, the amount of interest you pay could still be less than what you pay on a personal loan over the course of several years. And if you have some time, you could apply for a 0% intro APR credit card and potentially avoid interest altogether if you can pay off what you charge before the promotional rate ends.
- Borrow from friends or family. Another option when facing emergency expenses is to ask loved ones for help. Again, this isn't ideal, but it can be a temporary way to get back on your feet without dealing with high-interest debt. Just be sure you put the agreement in writing and pay the loan back as promised.
The Bottom Line
Using a personal loan to fund your emergency savings can be risky, especially if your credit needs some work. While there are some benefits, the risks may be greater for most people.
If you're considering a personal loan for any type of emergency, however, Experian can help you get matched with personal loans based on your credit profile.