How To Use A Personal Loan To Make Money

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.

Personal loans can also help you fund a new business venture, pursue education or increase your home’s value with home improvements. Understanding the risks and knowing how to use personal loans to build wealth can help you accomplish your financial goals.

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 loan to buy a car to get you to a new job. The payoff is the income you make.

A couple other examples of good debt are:

• Fund repairs on a rental fixer-upper: If you’ve got a knack for DIY work, you could buy rundown property and use a personal loan to fix it up to rent. If the rental income exceeds your mortgage and loan payment, you gain an asset that your tenant pays off.
• Obtain 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. However, be sure to balance out the return on investment of a degree and consider benefits of using a personal loan versus a student loan. Ensure that the benefits of furthering your education outweigh the associated costs.

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 a business or education.

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

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

1. If you are stuck in the cycle of revolving credit, getting a personal loan means you get a one-time lump sum that you must pay off by the end of the repayment period.
2. Personal loans have lower average APRs than credit cards, so you can pay less interest on your debt.
3. Consolidating debts into a personal loan can help you pay off debt faster and get to more financial stability.

Debt is often the biggest obstacle to wealth building. Credit card debt can be especially damaging because it hits your financial health in multiple 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.

2. 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.

There are many ways home improvements can build wealth:

• Building home equity: Upgrading your home can increase its market value, thereby building equity that can be beneficial when selling or refinancing the property.
• Enhancing energy efficiency: Making energy-efficient upgrades, such as installing solar panels, energy efficient appliances or improving insulation, can lower utility bills and increase the overall value of the property. Energy-efficient homes are increasingly attractive to buyers who are looking for ways to save on costs in the long run.
• Earning tax credits and incentives: Certain home improvements, such as installing solar panels, energy-efficient windows or upgrading to environmentally friendly systems, may qualify for tax credits and incentives. These tax benefits can even offset the cost of improvements and contribute to long-term savings.
• Improving property appeal: Renovations and updates can make improve the aesthetic of your home, making it more attractive to potential buyers and increasing its resale value. Upgrading features such as the kitchen, bathrooms or flooring can significantly impact the perceived value of the property.
• Reducing maintenance costs: Investing in home improvements can help prevent costly repairs down the road by addressing issues proactively. Regular maintenance, upgrades to essential systems like plumbing or HVAC can help preserve the home’s value.

3. Starting a business

Business founders can use personal loans for their business in a variety of ways, such as covering startup costs and accelerating expansion and scaling efforts. Personal loans can also be instrumental in launching new product lines, conducting market researching, expanding into new markets, renovating office spaces or enhancing customer service. Leveraging personal loans strategically can help founders seize better opportunities and propel the business towards more success. 

Be sure to compare whether a personal loan is a better option than a business loan. If you already have a financial history for your business, a business loan may the better route, but a personal loan may be easier to qualify for if you’re just starting out. 

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 lessons 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.

Personal loans can be a valuable tool for building wealth if used wisely. First, determine your debt tolerance so you can make responsible borrowing decisions down the road.