What is a personal loan? | Smart change: personal finance
Kiah Treece – Councilor Forbes
A personal loan is financing from an online or traditional lender that you can use for a variety of personal purposes. If you have to deal with travel expenses, home or auto repair costs, or other unforeseen expenses, a personal loan can help you access the money you need, sometimes as well. little that 24 hours. We will guide you how personal loans work, how to apply, and common alternatives to make sure you make the right decision.
How personal loans work
Personal loans are issued by a range of institutions, including online and peer-to-peer lenders, traditional banks and credit unions. The loan proceeds are distributed as a lump sum and interest begins to accrue on the total loan amount as soon as the loan is issued. Interest rates and repayment terms vary depending on the needs and qualifications of the lender and borrower. The origination fees also vary, but generally range from 1% to 8% of the loan amount.
The interest rates for personal loans depend on several factors, including the borrower’s credit rating, income and debt to income ratio. On average, rates vary from just 3% for the most qualified borrowers to 36% for applicants who present more risk to lenders. Personal loan interest rates are generally fixed over the life of the loan but can vary.
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In general, the duration of a personal loan, that is, the time a borrower has to repay a loan, ranges from two to seven years. However, as with interest rates, these terms vary depending on the lender, the amount of the loan and the creditworthiness of the borrower. A borrower’s loan offer will include details of amortization period, the amount of the monthly payment and the date on which the loan must be repaid. Use our personal loan calculator to get an idea of what your monthly payment would be.
Many lenders charge assembly costs to cover the costs of reviewing the borrower’s application, verifying their income, and processing the loan. These fees are usually between 1% and 8% of the total loan amount, but vary depending on the lender. In some cases, these fees are subtracted from the total loan amount, while other lenders add the fees to the loan principal.
Notably, not all lenders charge an origination fee on personal loans – in fact, many advertise no-fee loans – so take this into account when looking for the best deal.
Who is a personal loan for?
A personal loan is a great financing option for those who need access to a lump sum of money quickly and without limitation of use. While personal loans can offer quick and flexible financing, they can be expensive, with origination fees and interest charged on the total loan amount. For this reason, a line of credit can be a suitable alternative for borrowers who need money over a long period of time rather than all at once.
Applicants must have a credit score of at least 610 to 640 to be eligible for a personal loan. Even so, prospective borrowers with lower credit scores may also qualify for personal loans, although interest rates are likely to be higher and terms less favorable.
Types of personal loans
Personal loans can be secured, which means that the loan is secured by an asset like the borrower’s house, or unsecured, which means that no collateral is required. Interest rates are generally lower for secured loans because this form of financing presents less risk for lenders; for the same reason, these loans generally have more lenient borrowing requirements than unsecured loans. That said, whether it is a secured or unsecured loan is the best depends on the borrower.
Beyond collateral, personal loans can also have fixed or adjustable rates. Fixed rate personal loans are those where the interest rate and monthly payment remain the same throughout the life of the loan. It is the most common form of personal loan. In contrast, interest rates on adjustable rate loans change over time, typically starting low and increasing after a period of time.
If you think a personal loan may be right for your financial needs, familiarize yourself with the different types of personal loans before applying.
How to apply for a personal loan
Personal loans are available from online lenders as well as traditional banks and credit unions. Potential borrowers can usually apply for a personal loan online, but some lenders require an in-person meeting. Although the application process varies by lender, follow these general steps when applying for a personal loan:
- Check your credit score. Before you apply for a personal loan, check your credit score for free through your credit card issuer or other website that offers free scores. This will help you anticipate the likelihood of being approved and can give you a better idea of the type of interest rate you can expect. When applying for a personal loan, aim for a score of at least 610; however, a score above 720 will produce the lowest interest rates.
- If necessary, take steps to improve your credit score. Checking your credit score will also reveal if you owe improve your solvency before applying for a loan. You can then take steps to lower your credit utilization rate or make other improvements based on your credit report.
- Determine how much you need to borrow. Once you have an overall understanding of your credit score, calculate how much you want to borrow. Keep in mind, however, that personal loans are issued as a lump sum and you will have to pay interest on the entire loan amount, so don’t borrow more than you need to.
- Shop around for the best terms and interest rates. Many lenders offer an online prequalification process that allows you to estimate your likely interest rate with a simple application for credit. This means that you can search for the most favorable loan terms without damaging your credit score. You will often be able to prequalify in just a few minutes, but some lenders take longer.
- Submit a formal request and wait for a loan decision. After identifying the most competitive personal loan option available, submit a formal application. At this point you will need to consent to a firm credit check, that can impact your credit score, and the lender will identify the exact terms of your loan. Depending on the lender, this process can take anywhere from a few hours to a few days.
What can you use personal loans for?
Generally speaking, you can use personal loans for any personal purpose, unless specifically prohibited by a lender under the loan. However, there are many common reasons to get a personal loan. Here is a list of things that personal loans are frequently used for:
Having said that, lenders prohibit the use of personal loans to finance illegal activities. Some lenders also restrict the use of personal loans to cover education expenses or to refinance other debt. Depending on the lender, you may also be prohibited from using the proceeds of a personal loan to cover business expenses.
Personal loan alternatives
Personal loans are a flexible financing solution for eligible borrowers. However, depending on your needs and your creditworthiness, a personal loan may not be the best option, if not an option at all. Fortunately, there are several popular personal loan alternatives to consider:
- Savings. If you can cover your expenses with savings, instead of taking out a loan, you will avoid fees and interest. Keep in mind, however, that withdrawing money early from a qualified retirement account usually comes with an early withdrawal penalty. This option should therefore be avoided as far as possible.
- Credit card. Comparing personal loans vs credit cardsCredit cards generally have higher interest rates, but credit cards may be easier to obtain if your credit is poor. However, if you have a good credit score, you may be eligible for a 0% introductory offer, which can save you money on interest payments.
- Personal line of credit. Unlike a personal loan, which is disbursed as a lump sum, a personal line of credit allows borrowers to access funds up to a certain limit according to their needs. With this type of financing, the borrower only pays interest on what they actually have access to. This makes a line of credit a great option for projects or events where expenses will be spread over several months or years.
- Home equity loan or line of credit. Home equity lines of credit (HELOC) and home equity loans are financing options that are backed by a borrower’s equity in their home. If you are considering a loan secured by your home, consider the differences between HELOCs and Home Equity Loans before signing on the dotted line.