How Personal Loans Work: A Beginner's Guide - 2023

An Introduction to Personal Loan

Personal loans are a popular form of installment credit that delivers a one-time cash payment to borrowers. It can be used for various purposes, such as debt consolidation, home improvements, or unexpected expenses.

Personal loans are characterized by regular payment schedules, usually in monthly installments. The borrower receives their loans as a single payment, after which they must pay regularly based on the agreed-upon terms.

Fast and Easy Loan Options

There are now hundreds of fast and easy loan options available. Many lenders offer online applications that can be completed in less than 10 minutes.

The approval process may slow down to one business week, but receiving the funds is relatively fast. It can be completed within 24 hours after approval from same-day personal loan lenders.

Interest and Fees

Personal loans charge interest, typically expressed as an annual percentage rate (APR).

Aside from the interest, you should be looking for additional fees such as administrative and origination fees. These fees are not fixed and depend on the lender. Additionally, some lenders might charge a payoff penalty if you pay off your loan early.

How a Personal Loan Works

Overall

When you take out a personal loan, you borrow a fixed amount from a lender, such as a bank or a credit union. Once the loan is approved, you are required to repay the loan within a specified period, usually in monthly installments. In addition, the repayment terms are signed when you apply for the loan and generally cannot be changed. It usually includes the interest rate and repayment period.

Loan Approval Process

When you apply for a personal loan, the lender will consider several factors to determine your eligibility, including your credit score, income, employment history, and debt-to-income ratio.

Lenders have full authority over the approval process and might accept or deny your loan application based on their discretion. For instance, some lenders get borrowers with bad credit while others don't. If you are eligible for the loan, the lender will contact you to discuss the loan terms.

Funding and Repayment

After approval, the money will be deposited into your provided bank account. You can then use the funds for whatever purpose, such as paying off credit card debt, financing a home renovation, or covering unexpected medical expenses.

Repayment of the loan typically begins shortly after you receive the funds. You will be required to make regular monthly payments to the lender, usually for two to seven years. The repayment amount is dependent on the lender's interest rate and terms.

Nouns Related to Personal Loans

Understanding these key nouns is important when considering taking out a personal loan. Here are several vital nouns related to personal loans that you should be aware of:

1. Interest rates: This refers to the percentage of the loan amount you will be charged in interest over the loan.
2. Repayment timeline: This refers to the length of time over which you will be repaying the loan, typically in months or years.
3. Monthly payment: The amount of money you will be required to pay monthly to repay the loan.
4. Origination fees: A lender may charge fees for processing your loan application.

Types of Personal Loans

Several types of personal loans are available, each with unique features and benefits. Here are some of the most common types of personal loans:

Unsecured Personal Loans:

These loans are not backed by collateral and are based solely on the borrower's creditworthiness. As a result, they tend to have higher interest rates than secured loans. If you need to borrow money urgently but don't have any collateral, an unsecured personal loan can help.

Secured Personal Loans:

To take out a secured loan, the borrower uses the property of equal value or higher to the loan amount as collateral. Because the lender has some security in the form of collateral, secured personal loans tend to have lower interest rates than unsecured loans. The lender has the legal right to repossess any collateral should the borrower default.

Credit-builder Loans:

These loans are designed to help people build or improve their credit scores. The lender deposits the money into a savings account, and the borrower doesn't access it until after they have paid off the loan.

Throughout the loan, borrowers make regular payments on their balance. These payments are reported to the major credit bureaus, helping to establish a history of responsible credit use and potentially improving the borrower's credit score.

After paying off the loan, the borrower gains access to the money in the account. Some lenders may refund a percentage of the interest you paid, especially if you exhibit creditworthy behavior, such as making timely payments. By using a credit-builder loan, borrowers can build their credit history and improve their credit score, making it easier to qualify for other types of loans or credit in the future.

Specialized Lenders:

These lenders, usually companies and businesses, offer personal loans to customers as a way to retain clients and help them afford their products and services. For instance, you may get financing options when you purchase a new couch or bedroom set from a furniture store.

These loans are typically convenient, but it's important to carefully review and compare the terms to other personal loan options to ensure you get the best deal possible. Some specialized loans may come with higher interest rates or fees.

How to Obtain a Personal Loan

Obtaining a personal loan can be a straightforward process if you follow these basic steps:

1. Improve Your Credit Score

Your credit score will majorly determine whether you qualify for a personal loan and the interest rate you'll be charged. Review your credit report carefully and address any errors or negative information before applying for a loan.

2. Repay Existing Debts.

Lenders will look at your debt-to-income ratio when evaluating your loan application. Paying down credit card debt or other outstanding loans can improve your chances of being approved for a personal loan.

3. Conduct Extensive Research on Lenders for the Best Deal

Conduct research into different lenders before committing to a personal loan. A comparative assessment of the available lenders helps you get the best deal in terms of your financial situation, how fast you can get the loan, and the interest rates and repayment terms.

Once you've narrowed down your list of potential lenders, getting quotes from each of them is a good idea. You can compare each loan's interest rates, fees, and other terms.

4. Apply to the Established Channels

After comparing the loan offers, choose the lender with the most favorable terms and submit a formal loan application. The application process typically requires you to provide personal and financial information, such as your income, employment history, and credit score.

5. Follow Through on the Approval Process

After submitting your loan application, the lender will review your information and determine whether to approve your loan. This process may take a few days to a few weeks, depending on the lender and the complexity of your application.

6. Confirm the Receipt of the Loan

If your loan is approved, the lender will disburse the loan funds to you, typically in a lump sum. You can then use the funds for whatever purpose you need.

Factors That Can Affect the Cost of Borrowing From a Personal Loan

The cost of borrowing from a personal loan can vary depending on several factors. Understanding these factors can help you make informed decisions when choosing a loan. Here are some of the main factors that can affect the cost of borrowing from a personal loan:

1. Outstanding Credit Card Debt

If you have a lot of outstanding credit card debt, lenders may view you as a riskier borrower and charge you a higher interest rate on your loan.

2. Your Credit Score

The credit score is an essential factor of consideration for lenders, with some not offering loan options to borrowers with poor credit scores. The higher your credit score, the lower the interest rate you are likely to receive. If your credit score is down, you may be charged a higher interest rate or not approved for the loan.

3. Other Factors:

Other factors that can affect the cost of borrowing from a personal loan include the loan amount, the repayment term, and the lender's charges. Some lenders may charge origination fees or prepayment penalties, which can increase the overall cost of the loan.

How Do Lenders Determine the Interest Rates on Personal Loans

Annual Percentage Rate (APR)

When you take out a personal loan, the interest rate you'll pay over the life of the loan is determined by its Annual Percentage Rate (APR). The APR can be either fixed or variable, with a fixed rate staying constant over the life of the loan and a variable rate subject to change over time. In addition to the interest rate, the APR includes any fees or costs the lender charges.

Monthly payments are predictable

While some lenders may base variable rates on an index rate, such as the prime rate, most personal loans come with fixed APRs. This means your monthly payments will be predictable.

Factors determine your APR

Several factors determine your APR, but the most important is your credit score. A good credit score typically qualifies you for the lowest rates, often reserved for those above 700.

Other factors that may impact the APR you're offered include:

The amount and length of the loan

Generally, more significant loan amounts and longer repayment terms may result in higher interest rates.

Your debt-to-income ratio

You may be eligible for a lower interest rate if you have a high income and a low debt-to-income ratio. Conversely, you may be charged a higher interest rate if you have a low income or a high debt-to-income percentage.

Your income and employment history

Your income and employment history can affect your loan rates by demonstrating your ability to repay the loan.

Any collateral you can offer as security for the loan

Lenders may also consider whether you have collateral, such as a car or home, to provide as security for the loan, which can help reduce their risk and lower interest rates.

How Can You Use Personal Loans

Personal loans can be used for any purpose ranging from emergencies to leisure expenses. However, setting a goal before taking out the loan is recommended to avoid making unnecessary purchases using the money. Some of the common uses include:

Debt Consolidation:

You can use personal loans to combine high-interest debts, such as credit card balances, into a single loan with a lower interest rate. Doing so can save money on interest and simplify their repayment process.

Home Improvement:

They are especially ideal for homeowners who don't meet the requirements for other loans, such as lacking sufficient equity for a home equity loan. These loans offer a flexible financing option for upgrading a kitchen, installing a new roof, or making other improvements to a property.

Medical Expenses:

Personal loans can help cover unexpected medical costs, such as emergency room visits or surgeries.

Wedding Expenses:

Couples can use personal loans to pay for various expenses related to their wedding, such as venue rental, catering, and decorations.

Travel:

Personal loans can fund travel expenses like airfare, hotels, and activities. This can be a valuable option for those who want to take a trip but need more savings to cover the costs upfront.

Alternatives to Personal Loans

While personal loans can be an excellent option for financing large purchases or consolidating high-interest debt, there are better choices for some situations. Here are some alternatives to consider:

Credit Card

A credit card can be an alternative to a personal loan if you have excellent credit. Other cards, such as points and miles, provide various incentives which might benefit you. Look for a low Annual Percentage Rate (APR) card to minimize interest charges.

However, getting a credit card is crucial if you can pay off the monthly balance to avoid accruing interest charges.

Home Equity Loan or HELOC

Home equity loans (HELs) and Home equity lines of credit (HELOCs) are ideal loan options for homeowners. These loans allow you to borrow against the equity in your home, with HELs offering a fixed monthly payment and interest rate and HELOCs offering a variable interest rate that can change the monthly payment.

However, these loans require a certain amount of equity in your home to qualify, and you risk losing your home if you can't repay the loan.

Payday Loan

A payday loan is a short-term loan meant to be repaid with your next paycheck. These loans can be an option if you have poor credit, but experts strongly advise against them due to their high fees and aggressive collection practices. Fees for these loans can be equivalent to 300% APR or more significant and can lead to a cycle of debt.

You should also consider alternative payday loans (PALs) with lower fees and more extended repayment periods. These loans reduce some of the disadvantages of payday loans, making them a more attractive loan option.

FAQs About Personal Loans

1. How Much Money Can I Borrow Through a Personal Loan?

The maximum amount you can borrow with a personal loan varies depending on the lender and your creditworthiness. Some lenders offer loans up to $100,000, while others may have lower limits.

2. How Long Do I Wait Before Receiving Funds After Borrowing a Personal Loan?

The time it takes to receive the funds from a personal loan can vary depending on the lender and the complexity of your application. Some lenders may be able to disburse funds within a few business days, while others may take longer.

3. Is It Advisable to Use Money From a Personal Loan to Pay Off Other Debts?

Yes, personal loans can consolidate credit card debt and other high-interest debts into a single loan with a lower interest rate. This can help you save money on interest and simplify your debt repayment.

4. Does My Credit Score Affect My Eligibility for a Personal Loan?

Your credit score is one of the most important factors lenders consider when evaluating your loan application. Borrowers with higher credit scores can get favorable terms and interest rates and enjoy privileges such as expedited approval.

5. What Fees Are Charged When Taking a Personal Loan?

Some lenders may charge origination fees, a percentage of the loan amount. Other lenders may charge prepayment penalties if you pay off the loan early. Review the terms and conditions carefully before accepting a loan offer.

6. Does Having Bad Credit Prevent Me From Borrowing a Personal Loan?

Obtaining a personal loan may be more difficult if you have bad credit, but it is still possible. Nevertheless, plenty of lenders provide services catering to borrowers with bad credit.