A personal loan is a loan you can use to fund any purpose. But before you start scheming about what you’d do with an extra few grand, it’s important to understand how this type of loan works so you can determine if taking on this debt is right for your situation.
Common Reasons to Get a Personal Loan
While you could take out a personal loan to update your wardrobe or hit the slopes in Aspen, that’s not what most people do with the money.
Typically, funds from a personal loan go towards:
- Paying off or consolidating higher interest debt (usually from credit cards)
- Covering the cost of home improvements or repairs
- Responding to an urgent, unplanned for expense
- Flesh out a business idea
Terms of a Personal Loan
Now that we’ve looked at the primary uses of a personal loan let’s review the mechanics of how they work.
Secured vs. Unsecured
However, if you don’t qualify for an unsecured loan, or you’d like more favorable loan terms, you could ask the lender to make it a secured loan.
When taking out a secured personal loan, the lender will generally use your other accounts held at the institution as collateral in case you default.
Revolving vs. Installment
A personal loan is an installment loan. Which means you’ll make a payment each month until you pay off the obligation.
Depending on the terms, personal loan repayment periods typically span 2-7 years. Once you repay the note, the lender will close the account. If you need to borrow more, you’ll have to apply for another loan.
Interest rates on personal loans vary dramatically and can range from 5-36%, based on your creditworthiness and lender.
Better credit scores equate to lower interest rates, so it’s essential to keep your score as high as possible.
Additionally, while longer repayment periods result in smaller monthly payments, they also increase the total amount of interest you’ll pay, making the overall cost to borrow more expensive.
The good news? If you obtain a personal loan with a fixed interest rate, your monthly payment will never fluctuate.
In some cases, the principal and interest aren’t the only costs involved.
Sometimes, the lender will charge an origination fee for processing the loan. This fee may be as high as 6-8% of the loan and usually is taken right off the top of the borrowed amount.
If your loan will have this fee, be sure to factor it into the amount you apply for to ensure adequate funding for your needs.
Additionally, since lenders make their money from the interest you pay, they may include a pre-payment penalty in your loan terms. If you pay off the note early, the penalty helps to offset some of the interest revenue lost.
Before committing to a personal loan, read all of the terms carefully so you can be sure the monthly payment fits into your budget. And ensure you understand precisely what the loan will ultimately cost you.
Alternatives to a Personal Loan
Before you borrow any money, it’s important you know exactly what it’s going to be used for so you can consider potential alternatives.
In some cases, taking out a personal loan may be the appropriate financial product for your circumstances. In other cases, less so.
Personal Loan vs. Credit Card
A personal loan generally has a lower interest rate and a higher limit than a credit card (personal loans can lend you up to six-figures).
However, if you don’t need to borrow that much and you have access to an interest-free promotional period on a credit card, it could make sense to use the credit card instead. (Just be sure you can pay it off before the promotional period ends.)
Further, if your goal is to consolidate high-interest credit card debt, check to see if you qualify for a zero percent balance transfer. Here, you transfer the balance(s) from the high-interest card(s) to the no interest card.
Again, paying the card off before the promotion ends is paramount. If you miss a payment or have a balance when the promotion ends, your interest will jump up to a rate that may be higher than the rate you had previously.
Personal Loan vs. Home Equity Loans or Home Equity Lines of Credit (HELOC)
If your goal is to improve or repair your home, you may want to consider a home equity loan or a HELOC in comparison with taking out a personal loan.
With a HELOC, your interest rate may be lower than a personal loan, but it will likely be variable. This can make budgeting more challenging.
With a personal loan, you have to stipulate up front how much money you need and the lender disperses it all at once.
With a HELOC, you get approved for a certain amount, but only withdraw what you need as you need it. This could prevent you from overborrowing.
Most importantly, while personal loans are generally unsecured, a HELOC uses your home as collateral. Defaulting on a personal loan will likely result in collection efforts. Defaulting on a HELOC could result in foreclosure.
How to Get a Personal Loan
If you decide a personal loan is suitable for your needs, you can obtain one from a variety of places:
- Bank — brick and mortar or online
- Credit union — brick and mortar or online
- Loan marketplace — a website where you can compare loan terms from multiple lenders
- Peer to peer lending — get money from another individual, not an institution
But, before you spend a lot of time researching lenders, check your credit report and credit score.
If there are errors, try to resolve them before applying for a loan. If your information is accurate, but not as solid as you need it to be to qualify for the best rates, you may want to consider finding a co-signer.
While there are potential pitfalls with doing so, it may increase your chances of getting approved or receiving more favorable loan terms.
Additionally, since there are more potential lenders than ever (with new ones entering the market all of the time), it’s critical to do your due diligence before deciding to give an institution your business.
Check out their reputation with the Consumer Financial Protection Bureau and the Better Business Bureau to verify that they’re legitimate.
Further, like with any financial product, shopping around to ensure you get the best deal is a smart move.
Often, you’re able to comparison shop on a loan marketplace such as Lending Tree without it resulting in a hard inquiry on your credit report (which reduces your credit score a little).
Of course, when you submit a formal loan application, a hard inquiry will take place.
Tip: To see if your personal loan would fit into your budget, try this calculator.
Once you’ve chosen a lender and a specific loan, submit your application. If approved, you could have your money as soon as the next day.
To get off on the right foot with your lender, be sure to ask when your first payment is due and where it should be remitted.
Determining if a personal loan is right for you can be complex. Before taking one out, ensure you carefully consider your needs and do plenty of research on personal loans and any alternatives before committing.
Article written by Laura