Full Guide to Personal Loans
The personal loan market has exploded with the rise of online banking. Borrowers enjoy unprecedented choice as lenders compete hard to win business. If you’re in the market for a personal loan, you can consider offers from traditional banks and credit unions as well as online lenders, microlenders, and peer-to-peer lending markets.
No matter which way you ultimately decide to go, it’s essential to act from a position of knowledge and confidence. This complete guide to personal loans will teach you everything you need to know about the lending landscape.
Definition and Uses of Personal Loans
Finance professionals define personal loans as loans for individual, private borrowers who use their income and credit rating to secure funding. Most financial institutions advance personal loans in a single lump sum. The borrower then repays that sum, plus interest, in regular instalments.
You can use a personal loan for just about any reason. Financial institutions may ask you about how you plan to use the money, but most don’t actually track this and you are free to assign the money to any financial priority you like.
Common uses of personal loans include:
- Paying off multiple creditors to consolidate debt into a single channel
- Home improvements or repairs
- Engagement rings and weddings
- Family vacations
- Medical expenses
- Moving expenses
- Big-ticket purchases like furniture, appliances, home entertainment systems, or automobiles
- Launching or financing a small business or entrepreneurial venture
- Investing in opportunities likely to generate higher returns than the interest paid on the loan
Some people also take out loans to offer financial assistance to family members and loved ones who lack the income or credit rating to secure a loan on their own. Borrowers may also use the money to pay off lingering tax burdens or other forms of debt.
Loan Essentials: Interest Rates and Loan Terms
In addition to the amount of money you borrow, which is known as the principal, two other major factors define personal loans: interest rates and the loan term.
Interest rates are usually expressed as a percentage, which is annualized and applied to the loan principal. Thus, they are often called “annual percentage rates” (APR).
Loan terms define the period of time over which you are expected to repay the principal. These terms are usually configured in months or years. The process of paying off an interest-bearing debt to a financial institution over a fixed period of time is known as amortization.
Types of Personal Loans
Personal loans can be categorized in many different ways. The most common classification system divides them into two main types: secured and unsecured loans.
A secured loan is a loan in which the borrower offers another asset to the lender to act as collateral. If the borrower defaults, the lender takes possession of the collateral in order to recoup its money. For example, a borrower might offer his or her car as collateral for a $5,000 secured loan.
By contrast, an unsecured loan does not require the borrower to put any of his or her own assets at risk. The financial institution assumes that risk in exchange for earning interest on the loan. Thus, your credit rating—which essentially functions as an estimate of how likely you are to repay a debt—plays a major factor in determining whether you qualify for a given unsecured loan as well as the APR you will pay. The greater the risk you pose, the higher your APR will likely be.
Most borrowers prefer to obtain unsecured loans, as they carry less personal risk.
How to Qualify for a Personal Loan
If you’re thinking about applying for a personal loan, you should start by checking your credit score. Each of the three major credit reporting bureaus—Experian, Equifax, and TransUnion—are required by law to provide you with one free copy of your credit report per year. Your credit rating may be affected by your loan application, and your score will also suffer a ding if your loan request gets turned down. Thus, you should determine whether or not you will meet a lender’s eligibility standards before you submit your application.
You will also need to provide:
- Identity documents
- Proof of employment, self-employment, or business ownership
- Proof of income (pay stubs, bank statements, and/or tax returns)
Each lender maintains its own policies with regard to minimum credit scores. Some lenders specialize in offering personal loans to people with ratings on the lower end of the spectrum, while others will only consider borrowers with above-average scores. The amount you’re requesting will also factor into the lender’s decision.
Some general rules of thumb apply:
- The more you want to borrow, the higher your credit rating will need to be
- Consumers with “very good” or “excellent” credit (in the 700 to 850 range) will have access to larger amounts and lower APRs
- Borrowers will usually need at least a “good” score (in the 660 to 700 range) to qualify for high-value loans of $10,000 or more
Exceptions apply to these generalities, so check with each lender you’re considering for further information.
Tips for Comparing Lenders
With personal loans, the single most important consideration is to spend the least amount of money on interest as you repay the loan. Thus, you should consider both the APR and the loan term, as these factors work together to affect a given loan’s total cost.
Next, account for other expenses, fees and charges, and factors that could impact cost. These include:
- Origination fees: Some lenders apply a one-time origination fee to personal loans, usually calculated as a percentage of the loan principal.
- Early or late repayment penalties: You can also face penalties by missing payments or for paying the loan off too early, which costs the lender interest earnings.
In addition, you should carefully consider the lender’s reputation. Traditional banks and credit unions are likely to be trustworthy lenders, but evaluating nontraditional lenders requires a little more legwork. Use resources like the Better Business Bureau (BBB) and Trustpilot in addition to third party reviews.
Remember: reputable third-party agencies like the BBB and Trustpilot will paint a more accurate picture than consumer-submitted reviews. Most people only bother to write reviews when they’re had an unsatisfactory experience, and the Internet can distort reality. Large lenders may approve tens of thousands of personal loans in a year, and 100 bad reviews can appear much worse than it really is when considering they apply to maybe 1% of cases.
Personal Loan Risks and Hazards
Failing to honor your loan’s repayment terms will hurt your credit rating. If you default entirely, your credit score will be profoundly affected and it could take you years to undo the damage. In a worst-case scenario, a defaulted personal loan can be cause for a bankruptcy declaration, which is a disastrous outcome you’ll want to avoid.
To that end, keep the following in mind:
- Only borrow as much as you need
- Don’t borrow a sum of money or commit to a loan term that will put a heavy strain on your income as you repay it
- Always read and understand the fine print before signing off on the loan
- Avoid predatory lenders that “prey” on borrowers with low credit ratings by promising that they “approve everyone”
When managed correctly, personal loans can help you rebuild and improve your credit score. To help you make sound financial decisions, use tools like personal loan calculators to help you compare offers and accurately determine the true cost of the loan you’re seeking.