A personal loan is generally an unsecured amount of money borrowed from either a traditional bank, credit union, or online lender. These loans have fixed interest rates and terms. Interest rates vary depending on the lender and the borrower’s credit history and financial health.
There are virtually no restrictions on using personal loan funds, so borrowers can use these loans to pay for anything they want, including paying taxes. Before borrowers consider using a loan for taxes, they should consider what the best move is for their finances.
Should You Take Out a Personal Loan to Pay Your Taxes?
If you’re short on cash and worried about how you’ll pay your taxes this year, it might be tempting to take out a personal loan to help cover those costs.
Before deciding on this option, you should weigh the benefits and risks. Taking out a loan with interest and potential additional fees to pay expected annual expenses could result in higher debt, but personal loans offer fixed interest rates and repayment schedules that can sometimes be cheaper and more consistent than IRS payment schedules and other financing options.
Benefits of a personal loan to pay your taxes
- Plannable monthly payments: A major advantage of personal loans is that they come with fixed interest rates and terms. You should know exactly what you will be paying in interest, when you expect to make payments and for how long before you sign the loan. This predictability allows borrowers to plan ahead and ensures they end up paying no more than expected in interest. The terms for personal loans are usually between one and seven years.
- Low interest rates for borrowers with good credit: If you have good credit, you can get interest rates as low as 3 percent on personal loans. While exact interest rates vary based on the creditworthiness of the lender and borrower, borrowers with strong credit ratings generally have no trouble finding a reasonable interest rate.
- Faster and easier application process: Personal lenders tend to work quickly. The approval process usually takes place within a few days. Funds reach borrowers within 24 to 48 hours on average. While some lenders require you to complete the process in person, many allow you to complete the process entirely online.
- No collateral required: Unlike home equity loans or other types of secured loans, personal loans do not require borrowers to post collateral. That means you don’t risk losing an asset like your home or car when you take out a personal loan.
- Guarantee of the tax return: Although borrowing is always risky, taxpayers receive a tax return within 21 days of filing, guaranteeing that some funds will be available to pay off the loan. It may be wise to use your tax refund to pay off that debt. The average tax refund so far in 2022 is $2,323.
Risks of taking out a personal loan to pay your taxes
- Possibly high interest rates: Borrowers with less favorable credit ratings are unlikely to be eligible for lender minimum interest rates. These borrowers could pay up to an average maximum of 36 percent depending on their individual credit rating and financial health. The average interest rate for personal loans is currently around 30 percentmeaning borrowers struggling to get credit are likely to get even higher interest rates.
- Lender Fees: Individual lenders have their own fees, which may include processing fees, late fees, application fees, etc. Pay particular attention to processing fees, as these can range from 1 percent to 8 percent. It is important to know what fees you may incur before applying for a personal loan.
- Potential damage to creditworthiness: Every time you take on debt, your credit score suffers. If you’re able to make your loan payments on time throughout the life of the loan, you don’t have to worry about permanent damage to your credit score, and those payments can even help build your credit score. However, if you can’t repay your loan or are having trouble making payments on time, your credit score is likely to suffer.
- Could increase your debt to income (DTI) ratio: Your debt-to-income ratio is the amount of your debt relative to your income. If you take out a new loan and your income stays the same, your DTI will increase. This can adversely affect your ability to qualify for future loans or mortgages.
What happens if you can’t pay your taxes?
If you are unable to pay your taxes, you must contact the IRS to discuss your options. Simply ignoring your taxes will result in the IRS taking money from your wages, federal benefits, and future tax refunds to cover the original amount plus penalties and interest.
The IRS imposes different penalties for different offenses, including non-delivery, non-payment, and bounced checks. The IRS can also by law charge at least 2 percent interest on a payment of $1,250 or more.
Alternatives to using a personal loan to pay taxes
If you can’t pay your taxes this year, consider the following options before you decide to take out a personal loan to help cover the expenses.
IRS Payment Plan
The IRS offers payment plans to taxpayers who cannot pay their taxes at once. Individuals can choose between a long-term installment plan or a short-term 120-day payment plan.
Full payment within 120 days
For those who just need a little extra time to pay their taxes, this 6-month payment plan could be a solution. The IRS does not charge a fee for this plan, but interest and penalties will continue to accrue until you pay your tax liability in full. If you are able to make payments early and settle the debt before 120 days are up, it’s a good idea to do so.
You can also apply for an IRS Installment Arrangement if you need more time to pay off the debt. This plan involves telling the IRS how much you can pay per month, after which they can approve or deny your application. You then make the agreed payments over a set period of time. This option includes a $225 setup fee in addition to applicable interest and penalties. However, if you have a low income, you may be able to waive this fee.
Another option for those who are struggling to pay their taxes is to use a credit card to pay your taxes. If you qualify for a credit card with interest-free financing and a credit limit high enough to pay off your debt, this could be an affordable option. However, you are responsible for the handling fee, although this fee may be tax deductible.
If you qualify for interest-free introductory financing, it’s a good idea to pay off as much of your debt as possible before you have to start paying interest.
Using a credit card to pay your taxes tends to be a more flexible option than IRS payment plans or personal loans because of the lower average monthly minimum payments. However, credit card interest rates can be much higher, especially if you don’t have good credit.
If you have a 401(k) loan, you can borrow a 401(k) loan from your retirement plan. With this type of loan, you borrow money with the intention of repaying yourself. However, you’re still retired to pay interest on a 401(k) loan. Borrowers can borrow up to 50 percent of their account balance or $50,000, whichever is less. You usually have up to five years to pay off these loans.
These loans come with risks, including paying taxes and penalties on the loan if you don’t repay it on time. Again, these loans are employment-based, meaning if you quit your job before the loan is fully repaid, you have less than five years to repay it. In these circumstances, the borrower must file taxes up to their previous employer in the next year in order to repay their loan without paying penalties or defaulting on the loan.
For those struggling to raise the money for taxes this year, taking out a personal loan is a potentially good option. If you have good credit and are confident that you’ll have the money to pay off the loan soon, personal loans are a quick and easy way to get low-interest cash for borrowers with good to excellent credit.
However, dealing with interest and additional lender fees increases the cost of your loan, and your credit could be damaged if you have trouble paying back the loan. In some cases, taking out a personal loan to pay taxes can be detrimental to your overall financial health.
If possible, plan ahead for tax season to avoid this added financial stress. If you’re having trouble paying taxes this year, consider asking your employer to adjust your W-4 withholding taxes for next year or to adjust your quarterly estimated taxes if you’re self-employed. If that’s not enough for you, you can also consider opening a savings account specifically for taxes and depositing money in it all year round.
If you decide to take out a personal loan to pay your taxes, make sure you’re getting the best interest rates by comparing lender details before applying.