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Updated on Friday, May 22, 2020
Personal loans are a versatile form of credit. You can use them to consolidate other high-interest debts, pay for home improvements and more. Because they usually come with fixed interest rates and repayment schedules, you know exactly how much you need to pay each month and when your debt will be paid in full.
Still, taking on any type of debt is a serious responsibility. This personal loan guide will help you learn more about how personal loans work, which pitfalls to avoid and some alternatives to consider.
Part I: Personal Loans 101
How do personal loans work?
When you apply for a personal loan, you borrow a specific amount of money — most often at a fixed interest rate — for a set amount of time. Then you pay off your balance monthly until it’s paid in full.
The terms of your personal loan will depend on your unique financial situation and your lender. The loans are typically offered in amounts ranging from $1,000 to $50,000, and potentially even higher, depending on the lender. As for the repayment period, the loans’ terms often range from one to five years, but can potentially go up to 15 years for purposes such as home improvement.
Personal loans are unsecured debt, meaning they’re not secured by an underlying investment like a home or a car. For that reason, they usually come with higher interest rates than you might get with a mortgage or auto loan.
To get a real sense of how much a personal loan will cost you, keep an eye on the annual percentage rate, or APR. It includes interest and other costs, which could include an origination fee. An origination fee is a loan processing fee that can typically be 1% to 8% of the loan amount; however, some lenders, such as Lightstream and Discover, don’t charge any origination fees at all.
Pros and cons of personal loans
- Interest rates can be lower than credit cards. While interest rates on personal loan offers have risen lately, they can still be a good option for consolidating high-interest credit card debt, especially if your credit is top-notch. The average APR on a personal loan offer from a lender is now 11.81% for borrowers with excellent credit, and 15.61% for those with very good credit, according to recent data from parent site LendingTree; in contrast, companion site CompareCards lists the average APR on all credit accounts is 15.09%.
- Quick access to funds. Depending on your lender, you may receive funding for a personal loan in just a day or two.
- Predictable payments and interest. Because personal loans generally come with fixed rates and payment terms, you may not have to worry about your interest rate or monthly payment going up. That makes it easier to budget.
- Could lead to overspending. Personal loans can be used for almost any purpose, which could lead you to borrow more than you can afford to repay each month.
- Higher interest rates than some loan products. For example, if you have equity in your home and good credit, you may be able to get a better rate with a home equity loan or line of credit.
- Damage to your credit if you don’t pay. Some lenders offer options for borrowers facing financial difficulties, and may work with you if you lose your job or face other financial troubles. However, your credit might be damaged if you ultimately can’t make your payments.
What you may need to qualify for a personal loan
- Good or excellent credit. If your credit score is 640 or lower, it will likely be more difficult to get approval for a personal loan (although some personal loan companies might still work with you). By contrast, having good credit (a FICO score of at least 670) will give you more borrowing options, and a score of 740 will let you qualify for loans with your best interest rates and terms.
- Low debt-to-income ratio. Lenders might be hesitant to lend money if your debt-to-income ratio is too high. This ratio is determined by taking your total monthly recurring debt and dividing it by your gross monthly income. For personal loans, lenders usually like to see a DTI ratio of 36% or less. Still, even with a high DTI, you may qualify for a personal loan if your credit score meets a lender’s criteria, and you have both a solid income and credit repayment history.
- Cosigner or collateral. If you have a bad credit score, you may need a cosigner with good credit or collateral to help you qualify for a personal loan.
How to pick the best personal loan
Here are tips that can help you identify a personal loan that’s right for you:
- Shop around with different lenders. Gather information on personal loans to compare interest rates and loan terms from various lenders.
- Read the fine print. Make sure you understand your contract, your monthly payment and all terms and potential fees.
- Read reviews. Reading reviews of top personal loan companies can help you gauge the quality of each lender and what your experience might be like.
Part II: Common Uses for a Personal Loan
You might be surprised to know just how many uses personal loans can have. According to an April 2020 report from LendingTree, some of the top reasons applicants seek personal loans include:
- Credit card refinance: 32.0%
- Debt consolidation: 31.0%
- Home improvement: 8.5%
- Major purchases: 5.0%
- Car financing: 4.3%
- Business: 1.8%
These numbers don’t mean personal loans are the right choice in every borrowing situation. Here’s some more information about potential uses, along with some pros and cons:
Common uses for personal loans
|If you’re struggling to pay back several types of debt, a personal loan may let you streamline payments and pay less interest overall. One caveat: if you can qualify for one, a 0% balance transfer credit card could be a less expensive option for combining debt.|
Credit card refinance
|Personal loans often have lower interest rates than credit cards — just make sure you’ll actually save money after taking into account a loan’s interest rate, origination fee and repayment term.|
|If you don’t have enough equity in your home to qualify for a home equity loan or line of credit, a personal loan can help finance home improvements. It may, however, come with a higher interest rate.|
|A personal loan might cost less in interest than a credit card for that big buy of yours. Still, before taking on new debt, consider whether you really need that purchase now — or whether it would be cheaper to save up and pay cash.|
|A personal loan could be an option for buying a car, but it might be easier to qualify for an auto loan, as well as pay less interest and fewer fees (a car loan uses the vehicle as collateral).|
Small business financing
|If you’re starting a business and aren’t yet earning money, it may be tough to qualify for a business loan. A personal loan can help get your business off the ground. One potential red flag: If your business goes under, you’ll still have to pay back the loan or risk damaging your credit.|
|Taking out a personal loan to pay for medical expenses can keep medical bills from going to a collection agency. However, first see if your medical provider provides payment help, as many do. They may be willing to work with you to pay off your balance — and not charge interest.|
Part III: Personal Loan Traps and Scams to Avoid
Here are some personal loan traps you should consider:
Advance loan fees
Occasionally, a fraudulent loan company will offer outrageous loans and loan terms with a catch: You must pay upfront fees or “insurance” to qualify.
Look out for lenders who ask you to wire funds via Western Union or MoneyGram — reputable lenders won’t ask you to pay money upfront.
‘No credit check’ loans
According to the Federal Trade Commission (FTC), a lender who isn’t interested in checking your credit is a red flag.
Steer clear of ads and websites that promise “Bad credit? No problem” or “We don’t care about your past,” the FTC cautions. These slogans usually signal a scam.
Some personal loans might come with precomputed interest, which means they use the original payment schedule to calculate interest, even if you make payments early. This forces you to pay more interest over time, even if you make larger payments or try to pay off your loan early.
Some personal loans tack on a prepayment penalty if you pay your loan off early. And while prepayment penalties aren’t that common, they are unnecessary. Be sure to read through your loan terms to check for a prepayment penalty before you sign the agreement. If you find one, consider opting for another lender.
Part IV: Alternatives to a Personal Loan
Personal loans vs. credit cards
Credit cards can be a great deal if you pay them off monthly, as you have the potential to earn rewards.
Personal loans vs. HELOCs
A home equity line of credit (HELOC) is a revolving line of credit secured by your home. HELOCs often have lower interest rates than personal loans, and you may be able to deduct the interest if you itemize your taxes. By contrast, interest paid on your personal loan is not tax-deductible.
Personal loans vs. cash-out refinance
A cash-out refinance lets you take out a new mortgage that’s more than what you now owe, and pocket a portion of the loan as cash. It usually comes with a lower interest rate than a personal loan, but with longer terms, so you could end up paying more overall. If you’re opting for a cash-out refinance, check this calculator to determine how much you might be able to borrow, and what your new monthly mortgage payment will be.
Unsecured personal loans vs. secured personal loans
A secured personal loan requires borrowers to use an asset, like a vehicle or certificate of deposit (CD), as collateral. A lender can repossess the asset if the borrower fails to make payments, so interest rates on secured personal loans tend to be lower than those on unsecured loans.
FAQ: Personal loans
The amount you can borrow varies by lender, but generally ranges from $1,000 to $50,000.
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 few or no fees.
Your interest rate depends on the type of loan you apply for, how much you want to borrow and the quality of your credit. While each lender is different — for example, some will work with you if your credit isn’t ideal — a FICO score of at least 670 will give you more options.
If you were denied a personal loan due to poor credit, the best thing you can do is work on improving your credit rating. Pay bills on time, pay off debt to reduce the amount of available credit you’re using 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 home. You can also compare fees and interest rates from top personal loan companies by visiting this page.
If you apply for a personal loan, a hard inquiry will be placed on your credit report, but any negative hit your score takes will be short-lived. Your credit score will more likely take a larger hit if you borrow too much and can’t repay. On the other hand, repaying your personal loan on time, and ultimately in full, might actually help your score in the long run.
If you’re cash-strapped, this may sound tempting, but most mortgage lenders discourage it. Before approving you for a mortgage, lenders will look at your debt-to-income ratio, so taking on a personal loan to afford a down payment might actually disqualify you in the end.