Personal Loans Can Be Affordable -- but Here's Why You Might Overpay Today

It's not you -- it's the general borrowing environment.

If you're looking to borrow money, you may be aware that a personal loan will generally come with a lower interest rate than what a credit card will charge you. In 2022, many consumers took advantage of personal loans, to the point where total personal loan debt grew to $222 billion by the end of the year, as per TransUnion.

It's easy to see why personal loans are such a popular borrowing option. Because they're unsecured, you don't need to put up a specific asset as collateral. And personal loans let you borrow money for any purpose, whether it's to renovate your home, fix up your car, or start a small business.

But while personal loans are generally pretty affordable, at least compared to other borrowing choices, these days, you run the risk of seriously overpaying for one. Here's why.

It's more expensive to borrow across the board

You're probably aware that inflation has been a problem for consumers for more than a year now. The Federal Reserve has been trying to solve the problem of inflation by raising interest rates.

Now, the Fed doesn't dictate the borrowing rates personal loans come with. It doesn't set any consumer interest rates, for that matter.

Rather, the Fed oversees the federal funds rate, which is what banks charge each other for short-term borrowing. But when the Fed raises its benchmark interest rate, the cost of consumer borrowing tends to increase, too. And that's why you might get stuck with a higher interest rate on a personal loan today than you'd like.

How to snag a lower interest rate on a personal loan

Because personal loans are unsecured, the key to snagging the most competitive interest rate on one boils down to creditworthiness. If you have a high credit score, you're likely to qualify for a more attractive interest rate on a personal loan than someone whose credit is poor.

Before you apply for a personal loan, see what your credit score looks like. If it's in the upper 700s or higher, congratulations. That means you have really solid credit and are likely to snag a competitive interest rate when you apply for a personal loan. But if your score is lower, improving it might result in a nice amount of savings.

There are different things you can do to raise your credit score, but one area to focus on is your payment history. It carries more weight than any other factor when calculating your credit score, so if you make a point to pay your bills on time, your credit score could rise.

It also helps to check your credit report for errors, because a mistake like a misreported delinquent debt could be dragging your score down needlessly. Credit reports are available for free on a weekly basis this year -- a carryover benefit from the pandemic.

All told, you may find that a personal loan makes sense for you this year. But don't be shocked if the interest rate you're presented with is higher than you'd like it to be -- even if you happen to be a borrower with very strong credit.