What Is a Personal Loan? Your 2023 Must-Read Guide

What Is a Personal Loan?

A personal loan is a financing solution specifically offered for personal needs, which must be paid monthly over the loan term. Financial institutions like banks, credit unions, or online lenders typically offer it.

Personal loans are typically unsecured, meaning they do not require collateral, such as a house or car, to secure the borrowed funds. However, some personal loans may be secured, depending on the lender and the borrower's creditworthiness.

Personal loans can be used for various purposes, including consolidating high-interest debt, financing home improvements, or covering emergency expenses. Unlike a car loan or mortgage loan, a personal loan has no strict restrictions on the funding purpose, enabling the borrower to meet any immediate financial need.

Depending on the loan terms, personal loans come with interest rates, which can be fixed or variable. The interest rate, loan amount, and repayment term determine the borrower's monthly payment. In addition to interest, other costs are associated with personal loans, such as origination fees, prepayment penalties, and late payment fees.

How a Personal Loan Works?

Interest Rates:

Interest rates on personal loans are typically expressed as an annual percentage rate (APR), which represents the yearly cost of borrowing. The lender determines the APR based on the borrower's credit score, income, and other financial factors.

Lower interest rates are frequently available to applicants with better credit scores and vice versa. There are fixed-rate and variable rates. In contrast to variable-rate loans, which fluctuate over time depending on market conditions, fixed-rate loans have an interest rate that remains constant during repayment.

Monthly Payment:

The monthly payment is the total amount you pay on your loan, including principal and interest charged by the lender. How much you pay monthly generally depends on the loan amount, interest rate, and loan term. A longer repayment term usually results in lower monthly payments, but it also means the borrower will pay more in interest over the life of the loan.

Origination Fees:

Origination fees are one-time charges that lenders may impose for processing and underwriting a personal loan. The amount of these costs typically represented as a percentage of the loan amount might vary according to different lenders and the creditworthiness of borrowers.

Some lenders may waive the origination fee for borrowers with excellent credit or during promotional periods.

Repayment Timeline:

A personal loan's repayment timeline, or term, is when the borrower must make monthly payments to repay the loan in full. Repayment terms, determined by the loan amount and the financial situations of both the lender and the borrower, typically range from 12 to 84 months and remain fixed throughout the term.

Types of Personal Loans

Understanding the various types of personal loans will help you decide which loan is best suited for your needs and financial situation.

Unsecured Personal Loans:

Unsecured personal loans are the most common type of personal loan. They do not require any collateral, meaning you won't have to put up any assets (like your home or car) as security for the loan.

Lenders evaluate your credit score, income, and debt-to-income ratio to decide if you qualify for an unsecured loan. Unsecured loans typically come with higher interest rates than secured loans due to the increased risk for the lender.

Secured Personal Loans:

Secured personal loans require collateral, such as a vehicle, property, or other valuable assets, to ensure the loan. If you default on the loan, the lender can seize the collateral to recover their losses.

Compared to unsecured loans, secured loans pose less risk to lenders, leading to lower interest rates and more favorable terms. But you must repay the loan to avoid a potential loss of assets.

Specialized Lenders:

Some lenders specialize in providing personal loans for specific purposes, like home improvement, medical expenses, or education. These specialized lenders may create targeted loan packages with specific interest rates, terms, and conditions to address this demand.

Credit-Builder Loans:

Credit-builder loans are designed for borrowers with poor or limited credit histories who want to improve their credit scores. These loans work differently than traditional personal loans.

The borrower must make monthly payments on the loan to improve credit, while the lender transfers the loan amount into a savings account. After the loan is fully repaid, the lender informs the credit bureaus about the borrower's on-time payment records to build a good credit history. At the same time, the borrower can withdraw the pre-deposited money from the savings account.

Steps to Get a Personal Loan

1. Assess Your Needs and Financial Situation:

   It's essential to understand the required amount clearly and to borrow only what is needed. Evaluate your current financial situation and monthly budget to ensure you can afford the loan payments.

2. Check Your Credit Score:

   Your credit score is the most critical factor in determining whether you can get a loan. In addition, a high or low credit score will also affect the interest rate you get. Obtain a copy of your credit report and review it for errors. If you find any inaccuracies, dispute them with the credit bureaus to improve your credit score.

3. Compare different loan offers:

   Conditions vary with each lender. So you can compare them with each other. Banks or credit unions often offer competitive terms to their members. You can call or visit them in person to find competitive interest rates, favorable repayment terms, and the lowest fees. Look for competitive interest rates, favorable repayment terms, and minimal fees. Read customer reviews and check for any red flags or negative experiences.

4. Prequalification:

   Getting pre-qualified can provide you with a preview of potential loan terms and interest rates you're getting and has no impact on your credit score. It can help you narrow down your options and find the best loan for your needs.

5. Submit the formal application:

   If you have decided which lender to choose, you must prepare the documents required for application, such as your proof of income, employment history, and outstanding debts. Then formally apply for your loan to get the money. The lender may also request supporting documents, like pay stubs, tax returns, and bank statements.

6. Review and Sign the Loan Agreement:

   Once your application is approved, you will receive a loan agreement describing the terms, fees, interest rate, and repayment schedule. Before signing it, you should review the agreement carefully and understand all the terms.

7. Receive the Funds:

   After signing the loan agreement, the lender will disburse the funds within a few business days. You can get the funds immediately from your bank account or receive them in other ways, depending on the lender and your requirements.

Find the Best Personal Loan Lenders for You

Where to Find Personal Loans

Banks:

Traditional banks are a common source of personal loans. They usually provide competitive interest rates and may give current clients discounts or promotional rates. Some banks also have specialized loan programs for specific purposes, like home improvement or debt consolidation.

Credit Unions:

Credit unions are member-owned financial institutions typically offering lower interest rates and fees than banks. You might receive more favorable loan terms and customized services as a member.

Online Lenders:

Online lenders, also known as fintech lenders, provide a convenient and fast option for obtaining personal loans. With an easy-to-use online application process, you can fill out and submit the form in minutes. Also, good credit gives you a better chance of getting a low-interest rate.

How to Choose A Personal Loan

1. Compare Interest Rates:

   Compare different interest rates to get the best offer, which can help reduce your total loan cost and the installments.

2. Evaluate Loan Terms:

   Consider the repayment term and whether it fits your financial situation You can have lower monthly payments by choosing a longer loan term, which will increase your total debt cost. In contrast, choosing a shorter loan term means higher monthly fees and lower total costs.

3. Review Fees and Penalties:

   Check for any hidden fees or penalties, such as origination fees, prepayment penalties, or late payment fees. Some lenders may charge higher fees than others, so comparing all costs is crucial before deciding.

4. Assess Customer Reviews:

   Choosing a reliable lender with a good reputation who can provide high-quality service and solid customer support is important. You can compare different lenders by reading reviews and getting feedback from their existing clients.

Where Can You Use the Personal Loan?

Personal loans are flexible and can be used for a wide range of purposes, including but not limited to the following:

Debt Consolidation:

Consolidating high-interest credit card debt or other loans into a single, lower-interest personal loan can make your monthly payment procedures easier and reduce your interest cost.

For Home Improvement Projects:

Fund home renovations, repairs, or upgrades to increase your property's value or enhance your living space.

Pay for Emergency Expenses Without Draining Your Savings:

Instead of using up your savings, you can take out a personal loan to cover unforeseen expenses like medical bills, auto repairs, or funeral costs.

Major Purchases:

Finance significant expenses like appliances, furniture, or electronics, spreading the cost over time.

Finance Your Wedding or Dream Vacation:

Major purchases, such as weddings or trips, can be stretched out into installments over time with the aid of personal loans, making your payment easier to manage and avoiding using up all your credit cards at once. You can also pay for other once-in-a-lifetime events without incurring high-interest credit card debt.

Education Expenses:

Fund tuition, books, or other educational costs for yourself or a family member.

Pros and Cons of Getting a Personal Loan

Personal Loan May Not A Right for You If:

A personal loan is not the best option for everyone. Here are some situations in which you may want to explore alternatives:

You have bad credit:

You may only qualify for the best interest rates or loan terms with a high credit score. In this case, focusing on improving your credit score before applying for a personal loan may be more beneficial.

Your Debt-to-Income Ratio is high:

A high debt-to-income ratio can make securing a personal loan or obtaining favorable terms difficult. Lenders may reject your application in the first place or charge higher interest rates on your loan as it poses higher risks if they approve.

You don't have enough budget:

If you're struggling to meet your current financial obligations, there may be better choices than adding a personal loan.You should consider alternatives, such as reducing your spending or raising your income.

You want to cover unnecessary expenses:

Using a personal loan to fund nonessential expenses, like vacations or luxury items, can lead to unnecessary debt. It's important to consider whether the expense is worth the cost of borrowing and the potential impact on your financial future.

You have better finance solutions:

Depending on your financial situation and the purpose of the loan, there may be more suitable alternatives, such as a 0% APR credit card, a home equity loan, or a cash-out refinance. Be sure to explore all your options before committing to a personal loan.

How personal loans affect your credit score

Taking out a personal loan can positively and negatively affect your credit score. Here's how it may impact your credit:

Hard Credit Inquiry:

When you apply for a personal loan, the lender will conduct a hard credit inquiry to evaluate your creditworthiness. This inquiry can temporarily lower your credit score by a few points. But it usually has minor effects that don't last long.

Credit Mix:

Your credit mix, which makes up 10% of your FICO credit score, may be improved with a personal loan. A diverse mix of credit types, such as installment loans (personal loans) and revolving credit (credit cards), can positively impact your score.

Payment History:

At 35% of your FICO score, your payment history has the most impact on your credit score. Making timely payments on your loan can help boost your credit score. Conversely, late or missed payments can significantly harm your credit.

Credit Utilization:

If you use a personal loan to pay off high-interest credit card debt, your credit utilization ratio (the percentage of available credit you're using) may decrease. Your credit score may benefit from a lower credit utilization ratio.

Debt-to-Income Ratio:

A personal loan will increase your overall debt, potentially raising your Debt-to-income (DTI) ratio. A higher DTI ratio may negatively affect your credit score and make it more challenging to obtain new credit in the future.

In summary, a personal loan can help and hurt your credit score, depending on how you manage the loan and your other credit obligations.

Common Mistakes When Using a Personal Loan

To make the most of your personal loan and minimize potential drawbacks, be aware of these common mistakes:

Borrowing more than you can afford:

Only borrow what you need and ensure you can afford the monthly payments. If your debt is overextending your budget, you will likely fall into financial distress, potentially harming your credit.

Rushing into any quick decision:

Settling for your first offer might result in paying more than necessary. Before making the final decision, remember to shop around for different lenders and compare the offers available to you, ensuring you get the most competitive interest rates, fees, terms, and conditions.

Ignoring the loan costs:

Failing to take note of all the expenses linked with your personal loans, such as origination fees, prepayment penalties, and late payment fees, can lead to unexpected costs. Factor these costs into your decision-making process to ensure you get the best deal.

Neglecting the loan agreement:

Be mindful to review the loan agreement thoroughly and make sure you comprehend all of its terms and conditions. Make sure you're aware of any potential fees or penalties before signing.

Exploring Other Financing Options

If a personal loan isn't the right fit for your needs or you're unable to qualify for one, consider these alternatives:

Credit card

You can use a credit card to easily finance small expenditures, especially if approved for a card with a 0% introductory APR period. Remember that carrying a high balance on your credit card can negatively impact your credit score due to increased credit utilization.

Cash-out refinance

If you are a homeowner, cash-out refinancing uses your home's equity to leverage a new mortgage with a larger loan amount in place of your old one. And you will receive the resulting difference in cash, which you may spend as you choose. This option is best for those with a significant amount of equity in their home and who can secure a lower interest rate on their new mortgage.

Home equity line of credit (HELOC)

In addition to cash-out refinance, homeowners can also use a HELOC to access the equity in their homes. You can borrow money up to a set limit and have to pay it off with interest, much like a credit card. HELOCs typically have variable interest rates, which can fluctuate over time.

Home equity loan

Like a HELOC, a home equity loan allows you to borrow against your home's equity. But you must make a one-time payment with a fixed interest rate and repayment term. This option is best for those who prefer the predictability of fixed costs.

Specialized Lenders:

Personal loans from specialized lenders are designed to meet specific needs, such as home renovations, medical bills, or education. These specialized lenders may offer tailored loan products with unique terms, rates, and features to suit the specific need.

Credit-Builder Loans:

Credit-builder loans are designed for borrowers with poor or limited credit histories who want to improve their credit scores. These loans work differently than traditional personal loans.

The borrower must make monthly payments on the loan to improve credit, while the lender transfers the loan amount into a savings account. After the loan is fully repaid, the lender informs the credit bureaus about the borrower's on-time payment records to build a good credit history. At the same time, the borrower can withdraw the pre-deposited money from the savings account.

Frequently Asked Questions

Here are some frequently asked questions about personal loans to help you make an informed decision:

1. How can I get better interest rates on my personal loan?

If you want to reduce the cost charged by interest rates, you can build your credit, lower your debt-to-income ratio, and shop around for different interest rates offered by multiple lenders. Additionally, consider using a co-signer with good credit to increase your chances of getting a lower rate.

2. Can I make early payments without penalties?

It depends on the terms of your loan agreement. Some lenders allow you to pay off your loan early without any prepayment penalties, while others may charge a fee. Be sure to review your loan terms or speak with your lender to determine if there are any prepayment penalties.

3. How long does it take to get approved for a personal loan?

The approval process for a personal loan can vary depending on the lender. It may take several days for traditional banks or credit unions to assess and complete your application. At the same time, certain online lenders may offer immediate approval and fast financing within one business day.

4. Can I get a personal loan with a co-signer?

Yes. Some lenders allow you to apply for a personal loan with a co-signer. Finding a reliable co-signer with good credit and a steady income can help increase your approval rate and reduce the interest rate. The co-signer shares full responsibility for the loan once you fail to pay.

5. Can I get a personal loan with bad credit?

Yes. With bad credit, you may still get approved for a personal loan, but you may need more alternatives with higher interest rates and favorable terms. Consider improving your credit score before applying for a personal loan or exploring alternatives like credit-builder loans.