Should You Consider a Holiday Loan?
November 6, 2019 | By Ben Luthi
Holiday loans are personal loans that you can use to finance year-end holiday expenses, such as gifts, decorations and parties. Expenses around the holidays add up to about $1,000, according to the National Retail Federation's Holiday 2018 Consumer Trends report. That could be difficult for some consumers to manage without financing.
But while it's understandable to want the best holiday experience for your family and friends, holiday loans can cause more harm than good.
What Are Holiday Loans?
Holiday loans, sometimes also called Christmas loans, aren't a specific type of personal loan. Often, personal loan companies allow you to use your loan funds for any personal expense, including holiday-related expenses. As the end of the year approaches, lenders may use the term "holiday loan" to market personal loans for that purpose.
While the holidays represent a short-term need, personal loans typically aren't short-term loans. Among top lenders, you can have between two and seven years to pay back what you owe, although some may offer shorter terms. So while you'll have a monthly payment for a while, you won't have to scramble to pay back the loan in full within the next few weeks as you would with a payday loan.
Also, personal loans tend to charge lower interest rates on average than credit cards and short-term loans. According to data from the Federal Reserve for the second quarter of 2019, the average rate for a two-year personal loan is 10.63%, compared with an average rate of 17.14% for credit cards. Payday loans can have annual percentage rates upward of 400%.
The desire to get a personal loan for the holidays is understandable. The act of gift-giving is commendable -- and often expected during this time of year. But going into debt to make it happen could end up hurting your loved ones in the long run.
Why You Should Think Twice About Using Holiday Loans
If you qualify, a personal loan can give you an influx of cash that you can use to cover a variety of holiday-related costs. But after the excitement of the season ends, you may regret it. Here's why.
Averages don't tell the whole story. While the average interest rate on a two-year personal loan is relatively low, that's just an average. Like other loan types, personal loans typically have a risk-based pricing model. This means that your interest rate can be higher or lower based on your creditworthiness.
If your credit isn't in excellent shape, you may end up with an APR of more than 20% or even 30%. And if you have bad credit, some personal loans have interest rates in the triple digits.
"The better your credit, the lower your rate is going to be," says Katie Ross, manager of education and development and housing for American Consumer Credit Counseling. "But the longer the loan term, the more interest you're going to (pay) overall."
Also, the average rate may not include fees associated with the loan. Some personal lenders, for instance, charge an origination fee, which can be as high as 8% of the loan amount. That charge may be deducted from the loan amount before you receive it, but you'll still need to pay back the full loan amount.
It could break your budget. If you're looking at holiday finance options because you're living paycheck to paycheck and haven't been able to set money aside, adding another obligation to the mix could exacerbate the problem.
For example, let's say you take out a $1,000 personal loan with a 20% interest rate, 5% origination fee and a two-year repayment period. You'll receive just $950 from the lender, and your monthly payment will be $51. Even if that does fit within your budget, you'll end up paying $222 in interest over the life of the loan, which is a good chunk of cash you might want to use elsewhere.
"If you're already in a spot where things are tight, and you borrow money, now you add a payment on top of it," says Brandon Renfro, a certified financial planner and assistant professor of finance at East Texas Baptist University. "By the time you roll around to the next holiday, you're probably still feeling the effects from the previous one."
In some cases, lenders may prevent you from taking on debt you can't afford by calculating your debt-to-income ratio. That's the percentage of your monthly gross income that goes toward debt payments. If yours exceeds the maximum allowed by the lender -- which can be as high as 50% or more -- your application may be denied outright.
But if your budgeting woes are due to other reasons, such as medical bills or everyday expenses, those may not be completely represented in the DTI calculation, and you could still get approved for a loan you can't afford.
It can damage your creditworthiness. If you get a holiday loan and don't have the cash flow to pay it back, missing a payment could significantly damage your credit for years to come. Your payment history is the most important factor in your FICO credit score, and a late payment will remain on your credit report for seven years.
Even if you make on-time payments, that extra obligation will be included in your debt-to-income ratio the next time you apply for a loan. And if you actually need the money to buy a car or home or to cover emergency expenses, getting denied because of a high DTI can be devastating.
Also, most personal lenders run a hard credit check when you apply. This inquiry will remain on your credit report for two years and can knock a few points off your credit score temporarily. While this may not have a big impact on your creditworthiness on its own, the effect of one inquiry could be compounded if you've applied for credit multiple times in a short period.
Alternatives to Holiday Loans
Saving in advance for the holidays is the best course of action. But if it's already crunch time, here are some other options to consider.
Set a reasonable budget. It's easy to get caught up in the season of generosity, but if money is tight, it's best to create a budget to avoid overextending yourself. Take some time on this step to make sure you don't forget about important expenses that can ruin your budget later.
"If you spend $100 on gifts per person, maybe cut that in half or even further than that," says Ross.
Consider how much money you actually have to work with and try to stay within that. If you can't, look at some of the other options listed below.
Find more money in your budget. Take a look at your overall household budget and find out if there are any areas where you can reasonably cut back. Look for discretionary spending areas like entertainment, eating out and clothing instead of necessary expenses like rent, utilities and debt. Consider getting a seasonal job that can give you access to a little more income to help bridge the gap.
Note: Some lenders may offer to allow you to skip a payment during the holidays to give you some more room in your budget. In general, though, you'll need to pay a small fee to take the offer, and it will extend your loan repayment period another month -- which means more interest. Unless you're desperate and the upfront fee is minimal, it's best to avoid these promotions.
Consider a 0% APR credit card. If your credit is in good shape, you may be able to qualify for a credit card with a 0% APR promotion. These cards usually offer 12 to 18 months with no interest on purchases.
Some 0% APR cards even offer a sign-up bonus and rewards on top of their interest-free promotion. These cards can allow you to make holiday purchases and pay them off over time without interest charges.
But if you're going to go this route, remember that even if you're not paying interest, it's still debt. And if you don't pay off the balance before the promotional period ends, it could become expensive debt.
Finally, keep in mind that if you miss a payment on the card because of a tight budget, you could lose the 0% APR promotion and get slapped with the higher rate immediately.
"It all comes down to being able to pay your bills on time and having a plan," says Ross. "Because if you're already struggling, it doesn't matter that it's 0% or not."
Ask family members or friends for help. Asking someone close to you for a loan can be uncomfortable and can easily damage your relationship. But if you must, it may be better than taking on a personal loan or even more expensive holiday finance options. You're much more likely to be able to get a no- or low-interest loan and favorable repayment terms from a family member or friend than you are from a lender. Just be sure to draw up a simple contract and follow the agreed-upon terms.
Plan to Save for the Future
While your focus may be on the upcoming holidays, start looking ahead. Depending on how much money you typically spend during the holidays, plan to set aside a certain amount each week or month specifically for holiday expenses.
For example, if you usually spend $1,000, that comes to just less than $20 per week or a bit more than $83 per month. Breaking it down can make saving for future holiday seasons more manageable and less stressful.
"Don't just put it in your checking account," says Renfro, "because you'll inevitably think of a reason to spend it." Instead, set up a separate savings account for holiday savings , and create an automatic weekly deposit or transfer to the account. Physically separating the funds like this can also help you separate them mentally, so you're not tempted to spend that money on other things.