A personal loan works by providing you with funds that you can use for almost any type of purchase or expense. These loans are paid back within a fixed time frame along with an interest rate based on your qualifications.
The information provided on this website does not, and is not intended to, act as legal, financial or credit advice. See Lexington Law’s editorial disclosure for more information.
Personal loans are an option that you can turn to if you don’t have cash on hand for large expenses like home improvements, weddings or medical debts. There are many more situations where this type of loan is a better option than using credit cards or other lending options. But how do personal loans work?
Here, we’re going to cover how these types of loans work, what typical interest rates are and how this type of loan may affect your credit. There are a variety of lending options available, so knowing the pros and cons of these loans can help you make a better decision for your specific financial situation.
Table of contents:
- How do personal loans work?
- How much do personal loans cost?
- Should you get a personal loan?
- Pros and cons of personal loans
- How to take out a personal loan
- How does a personal loan impact your credit score?
What is a personal loan and how does it work?
You can use a personal loan for just about any expense or purchase. One thing you may want to know about personal loans is that depending on the lender, the loan may have to be used for a specific type of purchase. For example, if the lender specified that the loan must be used for the purchase of a boat, you wouldn’t be able to use the funds for a different purchase.
To acquire a personal loan, you can often go through your bank or credit union, and there are individual lending services that provide loans as well. When taking out this kind of loan, you’ll often have a fixed interest rate. Much like with other loans, you’ll have a minimum monthly payment, but you’ll often have the option to pay a larger amount in order to pay off the loan quicker and save on interest.
Types of personal loans
The two types of personal loans are unsecured and secured. The amount of the loan as well as the specific lender will determine which type of loan you qualify for.
Unsecured personal loans
Unsecured loans are loans that don’t require you to put down any collateral. The benefit of this type of loan is that your purchases are not at risk of repossession. These are also the types of loans that usually allow you to make any type of purchase with the borrowed funds. Unsecured loans may also have higher interest rates and stricter requirements for approval.
Secured personal loans
A secured loan is backed by collateral and is usually the type of loan you’ll receive when you’re requesting a larger amount for a big purchase, such as a vehicle, a home, home improvements or other large purchases. Purchases used as collateral to secure the loan are at risk of being repossessed if you don’t make your payments, but they also often come with lower interest rates and can be easier to get approved for.
How much do personal loans cost?
The cost of your loan will depend on the fees from the lender as well as your approved interest rate.
When taking out the loan, your lender may charge an origination fee, which may be between 1 percent and 8 percent of the loan. This fee is like a down payment and is charged for processing your loan application and providing the funds, though some lenders may not have this fee. Although unsecured loans don’t require collateral, borrowers still need to pay this fee to receive the loan.
Like with other loans that require regular payments, you may also be subject to late fees or prepayment penalties. When applying for the loan, it’s helpful to ask if there’s a prepayment penalty if you pay off your loan early. Some lenders charge this penalty because, while it saves you money on interest to pay the loan off early, the lender loses that money on their end. This is a way for the lender to recoup some of the lost revenue they were expecting.
How your credit score affects personal loans
Your credit score plays a big role in determining the interest rate of your loan, and a bad credit score may even disqualify you from receiving the loan. Although there are ways to get a loan with bad credit, improving your credit prior to applying for a loan can save you money.
For example, a bad credit score may result in a loan with an interest rate of 22 percent, but a good credit score can lower the interest to around 9 percent. On a $10,000 loan, the difference for the total repayment would be about $4,000.
How to get lower interest rates for personal loans
Regardless of your credit score, there are some ways you can get the best interest rate for your loan. Even with a great credit score, you may benefit from some of the following tips when taking out a loan:
- Improve your credit score: It can take some time, but improving your credit score is a great way to get better interest rates. A relatively small point improvement may save you hundreds or even thousands of dollars overall.
- Compare multiple lenders: If you have been with your bank or credit union for a long time, they may give you the best deal for your loan, but it’s still a good idea to do some research and get a few quotes from different lenders.
- Consider the length of the loan: You may get better interest rates by opting for a longer term for the loan. If you choose to do this, look at the overall cost, because extending the loan may mean that you pay more overall.
- Get a cosigner: A cosigner with a high credit score may be able to help you get a better interest rate on your loan. Keep in mind that a cosigner is a responsible party for the loan and can also be negatively impacted by missed payments or defaulting on the loan.
Should I get a personal loan?
This is only one type of loan that you can get, and while it may be right for you, it’s helpful to know about your other options. Interest rates are a primary factor when considering this kind of loan, so you may want to compare the interest rate and terms with those of other loans.
Personal loans vs. other lending options
Some of the alternatives to personal loans include credit cards and loans for homeowners. A balance transfer credit card is an option some people turn to because they may receive a much better interest rate. For example, some balance transfer credit cards offer no interest if the card balance is paid off within a certain amount of time.
Homeowners may benefit from looking into a home equity loan or line of credit. Also known as HELs or HELOCs, these loans may provide you with a large loan amount along with lower interest rates. When opting for this type of loan, your house is used as collateral, which means that the lender has the right to foreclose on your home if you default.
Pros and cons of personal loans
While reading, you may be asking, “Are personal loans bad?” but like all others, these loans have pros and cons. Your current and expected future financial situation is unique to you. By understanding the benefits and downsides of these loans, you may be able to make a more informed decision.
Benefits of personal loans
Personal loans are often a helpful option when you need access to a large amount of money because the amount can often exceed a credit limit on a credit card, plus credit cards often have higher interest. For example, some people take out a personal loan for in vitro fertilization treatment and other medical procedures not covered by insurance.
Additional benefits include:
- They can be used for nearly any type of purchase
- No collateral is needed for unsecured loans
- They can be used to consolidate other debts
Downsides of personal loans
This type of loan can be helpful for different financial situations, but you may want to research other options due to potential downsides. Some of these downsides include:
- There may be high fees and penalties
- There may be higher monthly payments than with other types of loans
- Collateral may be necessary for larger loans
How to take out a personal loan
To take out this form of loan, many people choose to go through their bank or credit union. This may be your best option if you’ve been with the financial institution for multiple years because they might give you the best deal on your interest rate. When you’re a loyal customer, you may have more leverage when trying to negotiate the terms of the loan as well. Alternatively, you can research outside lenders who provide loans, too.
Like when you apply for other loans, you’ll need to fill out a personal loan application with the lender. The lender will run your credit report to check your score and look for any negative marks like collections or bankruptcies. You’ll also need to provide additional documentation, which may include:
- Pay stubs
- Driver’s license or other forms of identification
- Proof of residence
- Financial statements
Common categories of personal loans
There is a wide range of purchases you can make with personal loans, but some lenders provide this type of loan for specific purposes. Here are some of the common categories for these loans:
- Medical loans
- Home renovation loans
- Debt consolidation loans
- Loans for bad credit
- Personal hardship loans
- Vehicle loans for cars, boats and motorcycles
What do you need to qualify for a personal loan?
In order to receive this kind of loan, you may need to meet certain qualifications. There are lenders who specialize in loans for those with bad credit, but many lenders will require a minimum credit score.
Some of the common qualifications you may need to meet include:
- Very good to excellent credit score: This may mean a credit score of 740 or higher.
- Regular income: Pay stubs or proof of other income may be needed.
- Good payment history: They’ll be looking for missed payments or negative marks on your credit report.
- Low debt-to-income ratio (DTI): DTI is calculated based on how much you make each month compared to monthly debt payments.
- Purpose of loan: Some lenders may only provide this type of loan for specific purposes.
- Ability to provide collateral: A secured loan will require you to have property like a home or vehicle for collateral.
How does a personal loan impact your credit score?
A personal loan can help or hurt your credit score. When you make payments on time each month, this activity is reported to the major credit bureaus and can help improve your score. Each on-time payment becomes part of your payment history, which is roughly 35 percent of your FICO® score.
Should you miss or make late payments, it can negatively impact your credit score. Depending on your score, the amount of points you lose may vary. And if you default on your loan and it goes to collections, this can stay on your credit report for up to seven years. A new loan also impacts your credit age and puts an inquiry on your credit, which can impact your credit score negatively for a short time.
Is a personal loan right for you?
Now that you have a wealth of information, you may find that a personal loan is right for you. If you’re in need of a large sum of money and can receive a good interest rate, a personal loan might be your best option. Just remember to do your research by shopping around and comparing lenders.
If a bad credit score is holding you back from getting a loan, it’s possible that you may have errors on your credit report that are negatively affecting your score. Lexington Law Firm has an experienced team of consultants who can work with you to challenge errors on your credit report. To learn more about how Lexington Law can help you work to get an accurate and fair credit report and monitor your credit health, contact us today.
Reviewed by Vince R. Mayr, Supervising Attorney of Bankruptcies at Lexington Law Firm. Written by Lexington Law.
Vince has considerable expertise in the field of bankruptcy law. He has represented clients in more than 3,000 bankruptcy matters under chapters 7, 11, 12, and 13 of the U.S. Bankruptcy Code. Vince earned his Bachelor of Science Degree in Government from the University of Maryland. His Masters of Public Administration degree was earned from Golden Gate University School of Public Administration. His Juris Doctor was earned at Golden Gate University School of Law, San Francisco, California. Vince is licensed to practice law in Arizona, Nevada, and Colorado. He is located in the Phoenix office.
Note: Articles have only been reviewed by the indicated attorney, not written by them. The information provided on this website does not, and is not intended to, act as legal, financial or credit advice; instead, it is for general informational purposes only. Use of, and access to, this website or any of the links or resources contained within the site do not create an attorney-client or fiduciary relationship between the reader, user, or browser and website owner, authors, reviewers, contributors, contributing firms, or their respective agents or employers.
Source: lexingtonlaw.com