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Updated on Wednesday, January 23, 2019
Loan contracts have a reputation as lengthy and complex, and can be packed with conditions and stipulations that cause just as many headaches as the responsibility for repaying the loan.
But personal loans tend to be simpler financial products with contracts that are shorter and easier for consumers to understand.
If you are wondering if you should get a personal loan, whether you want to buy a vehicle or pay for wedding costs, the product holds many advantages over a credit card. That doesn’t mean, though, that you should sign a personal loan document without reading it completely and understanding all its terms and conditions.
Understanding personal loans
It helps to understand what personal loans are and how they differ from other forms of consumer debt. Personal loans are generally not secured by collateral, such as a car or a house. Lenders offer approvals based on you as a borrower, looking at things such as your credit score and debt-to-income ratio.
“Some lenders will request some kind of income verification, like pay stubs,” said Gerri Detweiler, education director at Nav, a California and Utah company that provides small businesses with tools to help business owners manage credit and access financing. “New companies are trying to take other factors into account, like your education and what type of degree you earned.”
Americans are not strangers to relying on credit to help finance their dreams, and personal loans have a couple of popular uses. One is to consolidate debt, such as credit cards, and the other is to use the funds for a specific purpose and period. The funds might be used to remodel a home, buy a camper or for another use that will be paid off over time, such as a big medical bill.
“What I find is there are lots of consumers who would never carry a balance on their credit cards,” Detweiler said. “But they feel more comfortable with a personal loan because they are worried they might get tempted to buy things they cannot afford.”
Personal loans tend to be straightforward products that have fixed payment amounts at a fixed interest rate over a fixed period. Personal loans are considered nonrevolving debt.
In its Consumer Credit update in November 2018, the Federal Reserve found that Americans had $2.9 trillion in outstanding nonrevolving debt, which includes personal loans.
Details of personal loan contracts
A number of companies are lined up to extend personal loans to consumers, but that presents just as many potential pitfalls as it does opportunities. Take extra care to review the documents before committing to this kind of financing, even if you have more options to price and compare.
Beware of statutory liens with credit unions
When getting a personal loan from a credit union, you might be vulnerable to a lien on one of your deposit accounts with the institution if you are already an account holder and you fall behind on your payments. The Federal Credit Union Act empowers credit unions to retrieve the funds from one of your existing accounts to offset your outstanding debt, according to the Federal Register. That includes outstanding principal and interest, plus fees and charges. Be vigilant about offset provisions in the loan documents from credit unions. You do not always have to be a member of a credit union to get a personal loan from one, Detweiler said.
Pay attention to interest rate and repayment terms
This seems obvious, yes, but remember that personal loans are installment loans. You have to keep up with that fixed payment every month for the duration of the loan.
“It is geared to be repaid in a specific time, usually two to five years,” Detweiler said. “Your payments are going to be higher.” Ensure that you structure your budget so that you have enough cash on hand to cover those payments for the life of the loan.
Make note of the origination fee
An origination fee can be built into the loan. Lenders that have origination fees charge it when they disburse the funds, Detweiler said. An origination fee can be as high as 8%. Most online lenders that Detweiler has encountered do not charge origination fees. But they might if your credit is less than perfect. For instance, LendingClub, a peer-to-peer lending service, will charge an origination fee that ranges from 2.00% - 6.00% of your loan amount, depending on your credit and the information provided in your application. If you have credit issues, you might see a higher fee tacked onto your principal amount.
Be aware of late or prepayment repayments
If you are late with a payment, you might be charged a late fee. Also, if you set up automatic debits to repay the loan but your funds are short, your account will likely be overdrafted. That could incur a late fee, and, in the case of an overdraft on an autopay, a return fee.
Lenders sometimes discourage you from paying off a personal loan too early, which would reduce their revenue on the loan. Many personal loans skip the prepayment penalty, Detweiler said, but it does crop up from time to time. When it comes to personal loans, the best practice is to make the payments as scheduled for the duration.
Whether you want to buy a vehicle, consolidate debt or even build a tiny house, personal loans offer another advantage over other forms of consumer financing. Personal loans are repaid over a fixed term, with a fixed amount every month, so as long as the debt is paid on time, its existence will not harm your credit. You might carry a balance on a personal loan that is close to the borrowed amount, but that will not have the same impact as a high debt-to-ratio on a credit card, Detweiler said.
On a credit card, a high debt usage ratio in proportion to your available credit, around 70%, for instance, could negatively impact your rating, she said.
When researching your options for obtaining a personal loan, it is important to understand everything about how the lender operates, how your loan will be managed and what the potential penalties and charges are if something goes wrong. If you do not feel well-versed on every aspect of the loan, then stop, ask all your questions and make sure that everything is clear before you sign up.