Part I: Personal Loans 101
Personal loans are among the easiest financial tools to understand. When you take out a personal loan, a bank lends you money for a fixed interest rate and a fixed period of time.
This means you’ll be expected to make a fixed monthly payment for the life of the loan, but it also means you’ll face less uncertainty than with a credit card. With a personal loan, you’ll know exactly how much you borrowed, how much you’ll pay every month and when your debt will be paid in full.
This isn’t to suggest that personal loans are perfect. Like anything else in life, they come with risks and drawbacks. Most of the downsides depend on how responsible you are with credit and what interest rate you’ll pay.
Keep reading to learn more about how personal loans work, which pitfalls to avoid and how to get the most out of the loan you choose.
How personal loans work
As we mentioned, a personal loan is easy to grasp. You borrow money at a fixed interest rate, over a fixed amount of time, then you pay a fixed monthly payment until your loan is paid off.
While the terms of your personal loan can depend on an array of factors, these loans are typically offered in amounts up to $35,000. You may be able to borrow this amount for any length of time from 12 months to 20 years.
In addition to the interest rate you’ll pay, personal loans may also come with an origination fee, which can range from 1 percent to as high as 8 percent at some lenders, according to a review of personal loan terms on MagnifyMoney.com. On the bright side, it’s a competitive business and many lenders charge no origination fee or any other fees upfront.
The real costs to worry about with personal loans involve the APR. Interest rates charged through personal loans can vary quite a bit, and they are typically higher than you see with secured loans such as home equity or auto loans. That’s because personal loans are unsecured debts. Whereas a secured loan — think home or auto loan — is secured by an underlying investment (in these cases, a home or car), unsecured loans aren’t secured by an investment. The banks are taking on a greater risk lending without any collateral, so they charge higher fees and APRs as a result.
How to qualify for one
If you’re considering a personal loan, here’s what you’ll need to qualify:
- Good or excellent credit – Some personal loan companies will approve you with a credit score as low as 580, according to MagnifyMoney’s parent company, LendingTree. But having very good credit (a FICO score over 740) will put you in a position to qualify for a personal loan with the best interest rate and terms.
- Proof of ability to repay – You need to be able to show your ability to repay your loan, usually with pay stubs or other evidence of employment.
- Low debt-to-income ratio – Lenders may be hesitant to lend you money if your debt-to-income ratio is high. This ratio is determined by taking your total monthly recurring debt and dividing it by your monthly income. Discover Personal Loans notes that borrowers with a debt-to-income ratio below 36 percent may qualify for the best terms and rates on loans and mortgages.
- Co-signer – If your credit score is poor, you may need a co-signer with good credit to help you qualify for a personal loan.
How to pick the best personal loan
When it comes to personal loans, there is no one-size-fits-all option. The best loan for your needs depends on factors such as how much you need to borrow and whether you have good credit scores.
Here are some tips that can help you identify a loan that fits your goals:
- Shop around with different lenders. Thanks to the internet, it’s easier than ever to shop around and compare rates and loan terms. Our parent company, LendingTree, is an excellent place to start because you can easily explore options from different lenders in one place. Start by filling out an online form.
- Read the fine print. Make sure you understand each loan’s terms, conditions and interest rate, along with your monthly payment.
- Look for a low-cost loan. Ideally, you should look for a personal loan with the lowest rate and fees (or no fees) you can find.
- Read reviews. The internet is a treasure trove for reviews of various lenders. Reading product reviews can help you gauge the quality of each lender and what your experience might be like.
Part II: Common Uses for a Personal Loan
While borrowing money and paying it back slowly can be ideal no matter what your goals might be, you might be surprised to find out just how many uses personal loans can have.
“I’ve found that personal loans can be helpful when looking to consolidate higher interest debt, pay for a major expense or quickly get funds when needed for an emergency,” says Jeff Rose, founder of Good Financial Cents and partner of Discover Personal Loans.
Rose also pointed to a new survey from Discover Personal Loans, which showed that 26 percent of respondents cited a major medical expense as the most popular potential use for a personal loan, followed by 22 percent saying debt consolidation, and 13 percent using it to fund a small business.
Take note: That doesn’t mean personal loans are ideal for all uses. Here are some potential uses for personal loans, along with some pros and cons to consider:
If you have several types of debt and you’re struggling to keep up, consolidation can be a smart way to tackle the problem. When you consolidate debt, you take out a new loan, use it to pay off your existing debts and are left with just one loan to repay.
The real benefit of using a personal loan for debt consolidation is knowing exactly how much you pay each month and precisely how long you have until you’re debt-free.
“You don’t get that with a credit card,” says Gerri Detweiler, a writer, educator and authority on credit and loans.
You’ll have to decide when a personal loan makes sense as a debt consolidation tool over other options — such as a balance transfer credit card. It will likely come down to your credit score and which option will cost you the least over time. For example, a debt consolidation loan may have a higher interest rate than a balance transfer credit card, many of which come with a 0 percent APR for 12 to 21 months.
You can find 0% balance transfer offers at CompareCards.com, another LendingTree site.
Taking a personal loan to cover medical expenses “can be very helpful, especially if it keeps you out of collections,” Detweiler says.
Before you take this step, however, you should speak to your provider to see if it offers a payment plan. If so, you may be able to make payments on your outstanding medical debts without paying interest.
You can take out a personal loan to buy a car, but should you? Detweiler says it depends on the type of car you’re buying and how much it costs.
“You would probably get a better interest rate through a car dealership since personal loans are unsecured but car loans use the car as collateral,” she says.
On the flip side, a personal loan might work better if you’re buying an older used car from an individual instead of a dealership.
Detweiler notes that, while a lot of people use a home equity loan or HELOC, or home equity line of credit, to remodel their home, not everyone has enough equity to qualify. A personal loan could be ideal since you may qualify no matter how much equity you have in your home.
Not only that, but you won’t lose your home if you fall behind on payments with a personal loan. A home equity loan uses your home as collateral.
Moving can be expensive, but you should try to save up the cash before your move, if you can. If you’re short on funds, a personal loan or a credit card can work well. The best option for your needs depends on the interest rate you qualify for and how long repayment might take you.
Starting a business
Detweiler says she’s a big fan of trying to separate personal and business credit, but there are still times when using a personal loan to finance a business could be beneficial.
If you’re a startup that’s not yet earning money, for example, you might not yet qualify for a business loan.
“In that case, a personal loan could help you get your business off the ground,” she says.
Boosting your credit
“A personal loan can help you improve your credit mix, and that can boost your score,” says Detweiler. “But you shouldn’t get into debt just to build credit.”
If you want to build credit without getting into debt, signing up for a secured credit card and using it regularly can also help. Read more about how secured cards work.
When it comes to the unexpected, personal loans can be a better option than some other types of borrowing, like payday loans. Not only are interest rates typically low, but you can figure out an exact payment plan to pay the debt off before you sign up.
But first, you should “really think about whether you need to borrow or whether you could come up with the money another way,” says Detweiler.
When to avoid using a personal loan
While a personal loan can be a valuable financial tool, there are plenty of times where you might be better off borrowing money a different way – or not borrowing at all.
Joseph Toms, president of the nonbank consumer lender Freedom Financial Asset Management, says these instances really depend on individuals and their situation, although there are many telltale signs a personal loan is not for you.s
One of the biggest signs, he says, is when you can’t afford to keep up with the monthly payments for the loan you plan to take out.
“Not being able to keep up with the monthly payments means you won’t pay your loan on time,” he says. “If you pay your bills late or not at all, your credit will take a hit. That can lead to higher interest rates and cause your debt to spiral out of control.”
Before you take out a personal loan, you should write out a budget and make sure you can truly afford the monthly payments, he says.
Another time you shouldn’t take out a personal loan is when you don’t truly need what you’re borrowing for – or if you should probably live without it.
“A personal loan can be like a candy store,” says Toms.
The temptation of being able to borrow money can be too much for some people. It can inspire crazy actions, like financing purchases that can leave the borrower in financial peril, Toms says.
Another instance where you may not want to get a personal loan? “If you’re going to buy a house in the near future, you should think twice about taking out a personal loan,” Detweiler says.
This is because the amount you owe can affect how much you can borrow for a home.
Lastly, you should probably avoid a personal loan if you’re on shaky financial ground, says Detweiler.
“If you aren’t in a very stable financial situation, a personal loan could make your problems worse,” she says. “It’s risky because if you don’t make the payments, you could wind up hurting your credit and could end up in default or collections.”
Using personal loans for a vacation might be tempting, but it’s not the wisest choice. However, the truth is, some people do this anyway. In a recent survey, we found that 16 percent of people who said they are going into debt for vacation are using personal loans.
“Don’t borrow money and go into debt for a vacation,” Detweiler urges. “You’ll come back from vacation in debt. Save the money instead, or have a staycation.”
Like vacations, a wedding financed with debt is rarely a good idea.
“Don’t start your marriage in debt,” says Detweiler. If you have to use a personal loan for your wedding, make sure you shop around for a loan with the lowest interest rate and best terms.
If you believe you could pay the balance off in a short amount of time, you may also be better off with a 0 percent APR credit card.
The risks of using a personal loan
Taking out a personal loan can help you borrow the money you need to achieve any goal, but that doesn’t mean these loans are without risk. Some of the perils you’ll face when taking out any loan include:
- Overspending – A personal loan can be the answer to your prayers, but some experts say they’re almost too easy. “No one is going to question what you’re spending the money on, so you might use this loan to justify things you shouldn’t really buy,” says Detweiler. “If you go overboard, you can end up with debt that takes years to pay off and a lifetime of regret.”
- Damage to your credit if you don’t repay the loan – Obviously, your personal loan may go off without a hitch if you don’t borrow too much and can always afford your payments. “But if you can’t afford your payments due to job loss or another issue, your credit will see damage,” Detweiler explains. That damage can ruin your credit, or even lead to collections or bankruptcy.
- Bad financial habits – Getting into the habit of constantly borrowing money can make your life more difficult, she adds. While personal loans can be easy to get, relying on credit over and over can leave you short on cash to reach other financial goals.
And the benefits?
There are times to avoid a personal loan, without doubt, but these loans aren’t all bad. In the real world, there are plenty of instances where a personal loan can help you get what you want or even improve your financial life.
If you take out a personal loan – and do it in a financially responsible way – there are plenty of benefits to look forward to. These loans can:
- Simplify your financial life – “A personal loan can be a great tool for people looking to simplify and save by consolidating higher interest debt into one fixed monthly payment,” says Rose, of Discover Personal Loans. “If you have multiple credit cards or store card bills, and are having difficulty keeping track of them all, a personal loan can be a smart tool to streamline your payments and potentially save thousands of dollars on interest.”
- Help with emergencies – If you are hit with an unexpected expense you can’t cover, “personal loans can provide the funds fairly quickly to help manage through the situation,” says Rose. In that sense, a personal loan could actually save you from financial peril.
- Offer you predictable payments and interest – Because of the way personal loans are set up, you’ll never wonder how much you’ll pay each month or how much interest you owe. “Compared to higher-interest financial tools, having a fixed interest rate and monthly payment could save you money in the long run,” Rose explains.
Part III: Personal Loan Traps and Scams to Avoid
While there are plenty of reputable lenders in the personal loan space, that doesn’t mean it’s scam-free. Like most other areas of personal finance, there are plenty of fraudsters who will use personal loans to extract money from you or perpetrate fraud in some other way.
As you explore the world of personal loans, here are some traps to be aware of:
Advance loan fees
Occasionally, a fraudulent loan company will offer outrageous loans and loan terms with a catch: You have to pay the first few months of payments to qualify.
“They usually ask for these funds via Western Union or Moneygram,” says Detweiler. “But it’s a complete scam.”
No reputable lender would ask you to pay money upfront. “Do not pay money upfront for a personal loan under any circumstances,” she says.
Another one from Detweiler: the fraudulent lender who will offer you a personal loan, only to say you need to buy “insurance” to cover the loan in case you default.
This is also a scam because personal loans are unsecured – and because no reputable lender would require you to buy insurance to insure your own loan.
‘No credit check’ loans
According to the Consumer Financial Protection Bureau (CFPB), a lender who isn’t interested in checking your credit should set off alarms.
Ads that say: “Bad credit? No problem” or “We don’t care about your past” should be particularly worrisome, notes the CFPB. These slogans are usually suggestive of a scam.
Some personal loans might come with the caveat of pre-compute interest, interest that is stacked so you pay the bulk of it near the beginning of your loan term.
This is a bad deal, since you’ll wind up paying extra interest – even if you pay your loan off early. Before you take out a personal loan, make sure you know how interest is accrued and how it will impact the total costs of your loan.
Some personal loans will tack on a prepayment penalty if you pay your loan off early. Since this fee isn’t that common and is totally unnecessary, you should avoid loans that charge this fee altogether.
Make sure you read through your loans terms to check for a prepayment penalty. If you find one, look for another lender and loan.
Part IV: Alternatives to a Personal Loan
A personal loan might be ideal for helping you reach your financial goals, but it’s also possible a different financial product might work better. As you consider the prospect of a personal loan, don’t forget to explore your other options.
Here are some alternatives to consider, along with some instances where they may represent a better deal:
Personal loans versus credit cards
According to Paul Gentile, president of Cooperative Credit Union Association, there are definitely times where a credit card may be better than a personal loan.
“A credit card can be used to purchase something, so that can offer more flexibility,” he says. Credit cards can also be a great deal if you pay them off monthly, he notes, since you have the potential to earn rewards. Lastly, credit cards can be beneficial for certain short-term purchases since many offer 0 percent APR for 12 to 21 months.
On the flip side, “a personal loan may be better for someone who wants to make a large, intentional purchase that they planned for.”
Personal loans also offer the benefit of a fixed payment and payoff date, whereas credit cards can literally tether you to payments indefinitely if you keep using them for purchases.
Personal loans versus HELOCs
As Gentile notes, HELOCs come with the advantage of interest deductions (similar to how you deduct mortgage interest) if you itemize your taxes. In contrast, interest paid on your personal loan is not tax-deductible. Rates on HELOCs may also be lower than those on personal loans, he notes.
A possible downside with HELOCs is the fact that some only require you to pay interest for years. “This means you may not be paying anything toward the principal,” Gentile says.
Some HELOCs also come with balloon payments at the end, and those big payments may be hard to handle. On the other hand, personal loans come with predictable, fixed monthly payments and no surprises.
Personal loans versus peer-to-peer loans
Gentile notes that peer-to-peer lending is really similar to a personal loan. Both things allow you to borrow a fixed rate of cash and repay it over a predetermined length of time.
But since peer-to-peer lending isn’t regulated as heavily, this could be worrisome, says Gentile.
Before you choose among personal loans and peer-to-peer loans, make sure you compare all related fees, all total costs and interest rates.
Personal Loans versus cash-out refinancing
Gentile believes that opting for a cash-out refinance is the best option for people committed to their properties in the long term, whereas personal loans are better for short-term financial needs.
There are risks to getting cash out of your home as well, he notes. “If home prices drop, you could end up underwater.”
On the other hand, refinancing your home to get access to your home equity could help you qualify for a lower interest rate than a personal loan. “You also get to write off your mortgage interest, so you get a tax deduction,” notes Gentile.
Check out this cash-out refi calculator from MagnifyMoney’s parent company, LendingTree.
Frequently Asked Questions
Yes, if you use it to consolidate high interest debts from credit cards or other loans. To get out of debt faster, make sure your new personal loan comes with a lower interest rate than you’re already paying, along with no or few fees. Paying more than your minimum payment is another great way to pay down debt faster.
Your interest rate will be determined based on the type of loan you apply for, how much you want to borrow and the quality of your credit. Getting the best loan terms and the best interest rate typically requires a credit score of 740 or more, or very good or exceptional credit.
If you were denied a personal loan due to poor credit, the best thing you can do is take a few simple steps to improve your credit rating over time. Pay all of your bills on time, pay off debt to reduce your credit utilization, and avoid opening or closing too many accounts.
Thanks to the internet, you can apply for a personal loan online and from the comfort of your own home. You can also compare lenders, fees, and interest rates by visiting this page.
Because personal loans are unsecured, you don’t need collateral. What you do need is the ability to illustrate how you’ll repay your loan, along with a good credit score.
You can absolutely pay your loan off early; very few loans will charge a prepayment penalty. Before you take out a personal loan, you should make sure you won’t be charged a prepayment penalty if you’re able to repay your loan early.
While applying for a personal loan will result in a hard inquiry being placed on your credit report, any negative hit your score takes will be short-lived. Borrowing too much in relation to your credit limits can hurt your utilization, however, and yes, that could hurt your credit score.
On the other hand, repaying your personal loan on time, and ultimately in full, can actually help your score in the long run.
Depending on your lender, you may receive funds from your new personal loan as early as the next business day. However, it could take up to seven business days (or longer) if you apply for a loan on a weekend, have errors in your application, or your loan takes longer to process for any reason.
The best part about personal loans is that you can use the funds however you want. You can use the cash to pay off high interest debt, remodel your kitchen or buy a newer car, for example.
Just keep in mind that borrowing is never free. In addition to the interest you pay on your loan, you may also incur additional costs, such as origination or application fees.