How to make debt work for you: Build wealth with a personal loan

Although personal loans are debt products, they can be a great tool for building wealth if used correctly.

They can help you free up cash in your budget if used to consolidate high-interest debt, such as credit card debt. Less credit card debt also helps your credit score, which means you’ll qualify for lower interest rates if you need to get a mortgage or car loan in the future.

Personal loans may help you to fund a new business venture, take advantage of a good investment opportunity or even increase your home’s value with home improvements. Knowing how to use personal loans to build wealth can help you accomplish your financial goals  if you understand the risks.

How to use personal loans to build wealth

To build wealth with a personal loan, you must put it to good use.

You may hear finance experts discuss good debt versus bad debt. Good debt is any type of credit that produces a financial return on your borrowed money. Imagine you take out a personal loan to buy a car to get you to a new job. The payoff is the income you make.

Bad debt is typically money you borrow for experiences, consumable goods or depreciating assets.

Imagine you use a personal loan for a vacation rather than budgeting for it. There is no financial return on your money. You may make amazing memories, but the interest charges and monthly payments won’t help your financial situation.

A personal loan builds wealth by:

• Reducing your overall debt.
• Lowering your revolving debt balances.
• Increasing your home's value through home improvements.
• Helping you fund investments, a business or a side-hustle.

A personal loan reduces wealth if:

• Repaying eats into your savings.
• You use it to finance a want, not a need.
• It's a bandage for bad spending habits.
• You don't have a plan for what it's for.

1. Debt consolidation

Debt is often the biggest obstacle to wealth building. Credit card debt is damaging because it hits your financial health in two ways.

First, many people get used to making the minimum payment, which keeps you in debt longer. Second, it affects your credit utilization ratio. That can tank your credit score if it’s too high. A low credit score means higher costs when you borrow in the future. It can even affect your ability to rent a home or get a job.

Unlike credit cards, personal loans are disbursed in a lump sum and come with a set repayment schedule and a fixed interest rate. This makes them a better option when it comes to building wealth. These factors can help you avoid the temptations of revolving credit, such as overspending or only paying the minimum due. Both habits can worsen your financial situation.

Using a personal loan to consolidate debt can help you build wealth in five ways.

1. Your debt will have a payoff date: Personal loans must be paid off in one to seven years, which gives you a clear “debt-free” date. If you rid yourself of debt faster, you may accumulate less interest. Compare a loan against a credit card payoff calculator to see the difference.
2. You’ll likely pay a lower APR: According to Bankrate, the average credit card annual percentage rate (APR) is above 20 percent, compared to an average personal loan rate of 12.21 percent.
3. Your rate will be fixed: Personal loan rates are fixed for the term of your loan. Credit card rates can change from month to month.
4. Your credit score may increase: Paying off revolving debt can give your credit scores a big boost. A higher score means lower APRs and costs if you need credit in the future.
5. You receive your funds in a lump sum: You can’t re-use money you receive from a personal loan, and there’s no minimum payment option. The fixed payment schedule may keep you from borrowing more than you need.

2. Investing

There are a number of ways you can use a personal loan to invest. Some involve more risk than others, and should only be pursued with expert guidance from a financial advisor.

Additionally, some lenders may prohibit certain uses, especially buying stocks or funding tuition. Make sure to check with your lender before pursuing these options.

• Buying stocks: Using debt to trade in the stock market is very risky. Unless you have trading experience or can afford to lose the money you borrow, it’s probably not a good idea.
• Fund repairs on a rental fixer-upper: If you’ve got a knack for DIY work, you can buy rundown properties and use a personal loan to fix them up to rent. If the rental income exceeds your mortgage payment, you gain an asset your tenant pays off.
• Fix and flip houses: If you don’t want to be a landlord, you can improve properties and flip them for a profit. Most personal loans don’t require collateral to qualify, unlike a mortgage. So, you can get the funds you need without worrying about the condition of the house you’re repairing.
• Get extra education, training or certifications: Investing in yourself may make sense if it increases your earnings potential. The return on investment will come in the form of higher earnings and more promotions because of the extra skills you obtain.

3. Financing home improvements

Personal loans can also be used to build wealth by making renovations or improvements to a property that increases its value. Using a personal loan for home improvement gives you fast access to cash without tying up your home’s equity.

Some lenders offer repayment terms as long as 144 months for home improvement loans. That’s as long as some home equity loan terms.

They can also be a good alternative to secured loans, such as a home equity loan or a home equity line of credit (HELOC), as you do not risk losing your home if you default on payments. The approval process is also less involved because it doesn’t require an assessment of your home’s value.

It is important to choose renovations that have the best chance of increasing your home’s value. You’ll recoup most or all of the cost for these top renovations at resale:

1. Installing a new garage door.
2. Replacing your entry door.
3. Adding stone veneer.
4. Remodeling your kitchen.
5. Installing new siding.
6. Adding a deck.
7. Remodeling your kitchen.
8. Converting your HVAC system.

Assessing your debt tolerance

Before trying any of the above strategies, it’s important to understand whether they’ll fit your budget. That means assessing your debt tolerance.

Debt tolerance is a lender term related to how much you can afford to borrow compared to what you earn. Lenders set their own tolerance limits based on debt-to-income (DTI) ratio guidelines. However, it’s also important to look at your residual income, which is how much extra cash you have after paying for all your regular expenses.

Debt-to-income ratio

Your DTI ratio is measured by dividing your monthly debt payments by your before-tax income.

For example, if you make $10,000 per month and owe $3,000 per month, your DTI ratio is 30 percent (3,000 divided by 10,000 = 30%). Financial advisors often recommend keeping your DTI ratio to 36 percent or less — including the new debt you’re taking on.

However, lenders can set their own DTI ratios, and some allow you to borrow up to 50 percent of your income.

However, they often charge a higher rate for a high DTI ratio because of the added risk that you could default if your income suddenly drops from reduced hours or a layoff.

Residual income

Consider how much cash you have after paying your typical fixed and variable expenses every month. Your lifestyle may include eating out at restaurants, a long commute to work that eats up gas or braces or dance lesson for a child.

Will you have enough left after adding a loan payment to handle emergencies?

Don’t forget to consider your savings goals for retirement and education. Just because a lender approves you for a high DTI ratio doesn’t mean that your money habits can afford it.

What is considered rich?

Before you take out and invest in a personal loan, it’s important to consider your financial goals. How do you define success, and how much money must you make to get there?

According to Bankrate’s latest Financial Freedom Survey, the average American feels they need about $233,000 a year to feel secure or comfortable with their finances. That’s more than triple the nation’s average salary, which is slightly over $75,000.

However, that figure is too low for respondents to feel rich. In fact, Americans said they’d need a whopping $483,000 per year on average to feel rich or achieve financial freedom.

Other illuminating takeaways from the survey include:

• Only 28 percent of Americans consider themselves financially secure.
• 63 percent of Americans say they feel high inflation is holding them back from being financially secure or comfortable.
• Women’s average estimate of the amount of money they need to make to feel rich is $8,000 higher than men’s average estimate.

The bottom line

Personal loans can be a valuable tool for building wealth if used wisely. You might consolidate high-interest debt, invest in profitable ventures or finance home improvements.

However, it is important to determine your debt tolerance and make responsible borrowing decisions. With the right approach, personal loans can be a powerful tool for improving your financial situation and building long-term wealth.

So don’t be afraid to explore the potential of personal loans. Just ensure you make informed decisions that will lead you towards financial freedom.