If you’re stressed over the possibility of racking up holiday debt this year, you may be right to worry. In our 2016 holiday debt survey, 65.2 percent of respondents who added debt during the holidays said they did so unexpectedly and didn’t budget for the extra expenses.
This just goes to show what can happen if you take on debt without a plan. If you charge holiday purchases and don’t have a plan to pay them off, you can wind up making monthly payments for longer than you think — and fork over lots of interest payments along the way.
While most people said credit cards were the main source of their debt, nearly 9 percent said they used personal loans to finance their holiday spending, making it the third most popular borrowing option overall.
If you’re considering using a personal loan to fund your holiday shopping this year, it’s important to know the pros and cons first.
First up … what’s a holiday loan?
A holiday loan is simply a personal loan issued by a financial institution, like an online lender, bank or credit union. While these loans are intended to cover holiday expenses, they are not the same as other short-term loans such as payday or cash advance loans.
Since holiday loans are unsecured, you can borrow money without putting up anything as collateral. But because the lender is assuming more risk this way, these loans can carry very high interest rates. That being said, if you have good credit, relatively low levels of debt and sufficient income, you might qualify for lower rates.
Generally speaking, you can get a holiday loan (or other unsecured personal loan) in amounts up to $35,000 with several lenders. However, some may let you borrow quite a bit more. Your interest rate can vary depending on your creditworthiness, and the amount of time you have to repay your loan depends on how much you borrow and the loan terms you select. Personal loans are issued with a fixed repayment period, which can last up to 84 months.
Why get a loan for the holidays?
While some people budget throughout the year, setting aside money for the holiday season, there are plenty of ways to get off track. It’s possible that other expenses will pop up and cause your savings plan to go awry, or that you’ll need to pay for holiday travel or to get your home ready for guests.
Applying for a personal loan may be a good way to bridge the gap between the money you have and the money you need, says Jeff Rose, a certified financial planner and Discover Personal Loans partner. “Borrowing a set amount of money with a fixed repayment term and fixed rate can help you meet your financial obligations over the holidays while having a set budget with a clear payoff schedule, resisting the temptation to rely on revolving debt.”
Rose says he has seen situations where a holiday loan made sense. In one situation, an acquaintance of his was desperate to return home for the holidays to see his dying father on what could be his last Christmas. In that case, taking out a personal loan to travel home was “one of the best investments they’ve ever made,” Rose tells MagnifyMoney.
But, holiday travel isn’t the only reason to take out a holiday loan.
For example, the holidays are a popular time to propose, and “engagement rings can get expensive,” says Rose. You might even find the perfect ring that costs more than you have saved, but the time is ripe for asking.
“That’s where a personal loan can be a financially responsible tool to help you make this purchase,” he adds.
Or, perhaps you want to borrow money to cover the costs of holiday gifts, replace the appliances in your home or make a special purchase for your family.
What it takes to qualify
Getting a personal loan to cover expenses during the holidays is no different than getting a personal loan any other time of year, notes Rose. “Different lenders have different qualifications for loan approval and offer different rates, so my advice would be to research and find what fits your financial situation,” he says.
Generally speaking, however, some typical minimum requirements for a personal loan include being a U.S. citizen or permanent resident, being at least 18 years of age, and having a low debt-to-income ratio.
Your credit score may also impact your ability to get a personal loan. While it’s possible to get a personal loan with a FICO score of 500 or above, the best loan rates and terms go to those with good or excellent credit.
In addition to your credit score, another important requirement for getting a personal or holiday loan is that DTI — debt-to-income ratio — says San Diego financial adviser Taylor Schulte. To calculate your debt-to-income ratio, add up your monthly debt obligations (i.e. mortgage, auto loan) and divide that by your monthly gross income.
“Some experts say a debt-to-income ratio higher than 36 percent can dramatically reduce your chances of getting a loan or increase the interest rate to an unreasonable number,” he says. To improve your debt-to-income ratio, try paying down your existing debts,, picking up extra work to bring in additional income or putting on your game face and asking for a raise.
Schulte also notes that, if all else fails, you could ask a family friend or family member to cosign for your loan. While this can help you get a lower interest rate and better terms, this also means your cosigner is jointly responsible for repayment.
Holiday loans versus credit cards
While a holiday loan can be a good option for consumers who need cash to cover end-of-year or holiday expenses, some consumers also turn to credit cards to meet their needs. This strategy can be advantageous since some credit cards may offer a 0 percent intro APR on purchases for 12 months or longer. But, before you decide between a holiday loan and a 0 percent intro APR credit card, it’s important to note how each one works — and the reasons one option might work better for you than the other.
If you’re considering a personal loan, know that these financial products typically have a fixed interest rate and are structured with equal payments made over a specified time period. In that respect, a personal loan may be easier to pay off in a timely manner since you know exactly when your last payment will come due.
With a credit card, on the other hand, you’ll get access to a line of credit you can use to charge purchases. Because the amount you borrow may vary, you may not know your exact monthly payment. Plus, your monthly payment will increase as you use your card to charge more purchases.
While many cards offer 0 percent intro APR on purchases for more than 12 months, your APR, or interest rate, also resets after the introductory offer is over. If you don’t pay off your balance before that happens, you could wind up paying a hefty interest rate on your balance that is higher than what you would pay on a personal loan.
Things to watch out for
While borrowing money for the holidays can make sense, that doesn’t mean this option is foolproof. There are plenty of risks that come with borrowing.
Risk #1: Borrowing without a plan
Whether you decide to take out a holiday loan or charge your holiday purchases on a credit card, Rose recommends making sure you have a clear plan for the funds you borrow and a true need, along with the ability to repay the loan.
“Also, consider the repayment timeline and total cost of the loan, including any fees, from the start to ensure you can afford the monthly payments,” he adds
Any time you borrow money, you should also make sure you’re not borrowing to buy things you can’t truly afford — or just being wasteful in general. “Around the holiday season, it can be easy to spend more than you planned,” says Rose.
If you rack up too much debt and don’t have a clear plan to pay it back, you could wind up spiraling into more and more debt or taking years to pay it all off. And obviously, more debt inevitably leads to more interest charges layered on top.
Risk #2: Too many fees
Look for personal loans that do not charge additional fees — examples of these would be origination fees and prepayment penalties.
And understand other potential traps, such as with personal loan companies that precompute interest or ask you to pay for unnecessary insurance. In a precomputed loan, the total amount of interest that you would pay during the entire term of the loan is calculated and added to the balance up front.
Risk #3: Not shopping around
Another major risk of personal loans is that you won’t take the time to shop around, Schulte says. Through his personal experience, Schulte has seen how many people wrongly assume their primary bank is the best place to get a loan — even when that’s not even close to being accurate.
“It doesn’t hurt to start with your primary bank to see what they can offer,” says Schulte. “But, failing to shop around could literally cost you thousands.”
Schulte suggests shopping around with at least three to five lenders before making a decision. Fortunately, it’s fairly easy to get multiple loan quotes online.
We recommend you shop online to find lenders without those tricks and traps. A good place to start the search is with LendingTree, MagnifyMoney’s parent company. With a short online form LendingTree will perform a soft credit pull (with no impact to your score) and match you with multiple loan offers.
Because dozens of lenders participate in LendingTree’s program, you may also find lenders willing to accept borrowers with less-than-perfect credit.
Tips for financial success during the holidays
There are a number of things you can do throughout the year to help yourself financially when the holidays roll around, Rose says. If you’re eager to make the most of this holiday season, or at least escape the holidays with minimal financial damage, consider these suggestions:
- Save for the holidays all year long.“If each month you put a portion of your income in a separate account designated for holiday spending, you should have a nice amount of money set aside when the season arrives,” says Rose. While it may be too late to start saving for this year’s holiday season, it’s never too early to start saving for next year.
- Set appropriate expectations for your family.Whether you’re worried you’ll have a skimpier array of gifts under the tree or not, Rose says it’s important to have an upfront conversation with your family (spouse and children) about how many gifts they are going to receive and how much you’re going to spend. “It’s easy to get caught up in the season and start adding more and more to the pile and buying stuff you don’t need,” he says.
- Stock up on gifts all year long.“You can also take advantage of buying gifts when retailers are having big sales,” says Rose. On Cyber Monday, you can typically get huge savings on everything from clothes to electronics. Buying in advance on these type of sales is huge, and right after this year’s holiday season can be a great time to stock up on next year’s gifts.
- Opt out of gift exchanges.If you’re involved in multiple gift exchanges or “Secret Santa” arrangements, opting out for the year can help you save some cash. By not participating in these holiday “extras,” you can save money for the gifts that are most important.