Taking out a personal loan is a big financial decision that can impact various aspects of your personal finances, potentially long-term, and therefore isn’t something to be considered lightly. It’s important to understand the ins and outs of personal loans, the advantages and potential drawbacks, interest types, and possible effects on your credit score and history.
If you’re considering a personal loan, think about why you need one and be honest with yourself about your financial behavior. If your need is due to excessive spending and debt, a loan may not solve the greater issue. In this guide, you’ll learn how personal loans work, some of the reasons to consider one (and when not to), and tips for finding one best suited to your needs.
What is a personal loan?
A personal loan is money that you borrow from a bank or other financial organization. Unlike a home or auto loan, it can be for a broad reason, such as a vacation or major purchase, and doesn’t have to be reserved for a specific purpose. You can use a personal loan to pay off high-rate credit cards and other high-interest debt, to make home improvements, and more.
How personal loans work
Most personal loans are considered installment loans. Generally, funds are disbursed as a lump sum directly to the customer or member, which they pay back in pre-determined monthly installments until the loan’s term is complete. These loans are issued by banks, online lenders, and credit unions – with the loan terms, lending limits, and credit requirements differing by lender.
You can usually select a specific rate and term
Loans can have fixed- and variable-rate options, with some lenders offering repayment periods usually ranging from 12 to 60 months (about 5 years). There is usually a minimum and maximum amount you are permitted to borrow.
Personal loans can be either unsecured or secured
Unsecured loans are most common and generally require a strong credit score to qualify, as they are not protected by collateral or an asset. Secured loans are protected by collateral or an asset. The difference between the two loan types can often be seen in their timelines and flexibility, among other factors.
Unsecured loans
- Unsecured loans are not backed by collateral or an asset
- Rates and terms are dependent upon the borrower’s credit score and income, with some lenders requiring additional data like employer and education information.
- Although the APR is usually higher than a secured loan due to the riskier nature of the loan, it is still typically lower than many credit cards.
Secured loans
- Secured loans are backed by collateral, such as a car or a savings account.
- Rates and terms are dependent upon the borrower’s credit score and income, with some lenders requiring additional data like employer and education information.
- Interest rates and fees are generally lower compared to those of unsecured loans because the lender may take ownership of the collateral if the borrower defaults on the loan.
Pay Attention to APR
Annual Percentage Rate (APR) is the cost of the loan, including interest and fees, displayed as a percentage. It represents the annual cost as opposed to the monthly rate, giving you a more accurate representation of what you’ll pay for the loan annually.
Fixed and variable rate loans
One important factor in your loan decision may be whether you select a fixed rate loan or a variable rate loan. Though this may seem simple, there are qualifications and considerations for each option.
Fixed rate loans
Variable rate loans
With a fixed-rate loan, the interest rate remains the same throughout the loan’s duration, resulting in a predictable monthly payment. As such, it is a strong option for those looking for a definitive budget over the life of the loan.
A variable rate loan usually has a lower initial interest rate than a fixed rate loan but is adjusted based on a benchmark interest rate known as an index, which may rise over time. When the index rises, it leads to higher monthly payments and a greater total loan cost. Variable rate loans can be a strong alternative if you plan on repaying your loan quickly — you can take advantage of the lower initial rate, pay off the loan before it rises, and therefore potentially pay less interest over the
Minimum & maximum loan amounts
It is important to be aware that lenders have varying minimum and maximum loan amounts for personal lending. Each lender has its own criteria, and other variables, such as the reason for taking out the loan, can also play a role. For instance, Laurel Road offers personal loans with different maximum amounts depending on the usage, with options for debt consolidation, home improvement, and options for major purchases.
Reasons to take out a loan
One of the most attractive features of a personal loan is the flexibility around how borrowers can use the money. Here are a few of the most common reasons to take out a personal loan:
Reasons not to take out a personal loan
When total cost overshadows the benefits, a personal loan is not an ideal choice. It’s important to consider additional fees, as well as your intended purpose for the money.
Additional fees
There are several fees to consider that impact the total cost of your personal loan:
Interest rates
Rates can vary widely (anywhere from 3% to 36% and up) depending on the lender and the borrower’s credit score. In general, the higher your score, the lower your rate will be. Be aware of your credit score ahead of time and shop around to make sure you’re getting the best rate.
Origination fees
Some lenders apply a fee for processing the loan. Generally, this fee can equal 1% to 6% of the loan’s total amount and is reflected in the loan’s APR.
Prepayment penalties
Some lenders will charge a fee if the borrower pays off the loan early because it means the lender will not benefit from some of the interest it would have otherwise received.
Non-essential consumer purchases
For large consumer purchases like jewelry or electronics, you may be able to receive a better interest rate with a personal loan than you would using a credit card — but you are still paying interest regardless. Saving up for that specific purpose instead may be a better overall plan. Carefully consider your use and repayment plan for the money.
Top tips when shopping for a personal loan
If you’ve decided a personal loan is right for you, here are some rules to follow and items to be aware of:
Compare terms and conditions
Look at different lenders to find the best possible terms.
Look at the duration of the loan
Some lenders offer three-, five-, or seven-year loans, with higher interest rates for the longer-term options.
Consider “soft credit pulls” instead of “hard credit pulls” when shopping around
A soft pull does not impact your credit score, and some lenders use them to provide conditional rates and loan terms early in the borrower’s application process.
A hard inquiry (meaning the lender pulls your full credit report) occurs when the borrower applies for a loan and the lender uses it to make a final rate offer. A hard inquiry usually lowers the credit score by a few points –this is temporary, but worth knowing about. On occasion, the inquiry may stay in the borrower’s credit reports for approximately two years.
Consider your options — and your bottom line
If you are considering a personal loan, think about all of your options, and be honest with yourself about your financial behavior. If you have a specific need, have considered the comparative rates and options, and can create a viable financial plan to put in place for repayment, a personal loan may be a strong option. Do your research and determine the best course of action for your financial situation.
