How Do Personal Loans Work?
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How Do Personal Loans Work?

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There’s no shame in needing an extra infusion of cash to make things work. Businesses do it all the time as a strategic move, taking out business loans to ensure smooth operations or grow into new areas. As an individual, you may have strategic reasons for borrowing, too, and luckily there’s a type of lending just for you — a personal loan. If you’ve heard of personal loans, you may wonder, “How do personal loans work?”

Personal loans are offered by banks and online lenders, and can be used for a wide variety of needs, from making a home repair to paying for dental work. While it’s important to be careful not to become overextended in your borrowing, personal loans can open up new possibilities, act as a lifeline in tough situations and even help you repair your finances when you’re badly in debt.

The personal loan landscape is very active, with a wide range of lenders competing for borrowers. This means that you’re likely to be able to find a loan product that will work for you, even if your credit score leaves something to be desired. For those with good or excellent credit borrowing is often affordable and easy.

 

What is a personal loan?

A personal loan is a fixed amount of money given to an individual by a bank or other lender that comes with a fixed interest rate and a fixed repayment term.

Personal loans are unsecured, which means that there is no collateral involved. Because of that, the lender has little recourse if you don’t pay the loan back: they can’t, for instance, repossess your car the way they could if you failed to pay a car loan for which the vehicle served as collateral. Because the lender has no recourse, personal loan interest rates tend to be relatively high compared to secured loans.

Uses for a personal loan

Personal loans are extremely flexible; they can cover almost anything assuming you have a credit score that will inspire a lender to take a bet on you. There are many solid reasons for borrowing a bit of cash, including replacing an appliance, covering medical costs and paying for unexpected emergency expenses, to name just a few.

There are two rules of thumb to keep in mind when taking out personal loans:

Only borrow money you know you will be able to pay back in a timely manner.
Don’t increase your debt load for insufficiently important reasons.
Taking out a loan when you have no extra income to pay it back over time is a mistake — a potentially very costly one. It’s also probably not a good long-term financial strategy to pay for vacations, gifts or other luxuries with borrowed funds, even if you can pay the loan back on schedule. Instead, you could invest that money you’re paying in interest on the loan, improving your overall financial outlook.

One of the most common — and most strategic — reasons to take out a personal loan is to reduce higher-interest debt. Indeed, upwards of 60% of personal loans are used to consolidate debt or refinance credit cards, according to a study by LendingTree, which owns Student Loan Hero. Consolidating debt means paying off several debts with one new loan that has an interest rate lower than the average of the loans being paid off.

This tactic is intended to lower the overall interest you are paying on your debt, thereby reducing the amount you’ll end up paying and/or the time it takes to pay it off. You can use an online credit consolidation calculator to figure out exactly how much you could save. Consolidating debt also results in a single payment due every month instead of a cascade of payments, making managing your debt that much easier.

The different elements of a personal loan

The details of personal loans shift depending on the details of the situation, such as the borrower’s credit score, the amount being borrowed and the lender’s rate schedule. Here are some of the elements of a personal loan to consider as you’re shopping around:

Interest rate: The interest rate, usually given as a percentage of the loan amount, is the amount you will pay on top of the principal of the loan. Interest rates for personal loans are usually fixed, meaning that the rate stays the same throughout the life of the loan. On occasion, rates can be adjustable, meaning they’ll fluctuate.

APR: The APR is the interest rate plus other fees that you must pay per year to borrow the loan, such as origination fees and service charges. This is basically the total annual cost of borrowing the money, and it can range from very reasonable to extremely high, depending on your credit score, typically varying between 7% and nearly 136%. In 2018, the average APR on personal loans was 33.52%, according to LendingTree.

Borrowing minimum/maximum: Lenders will often have floors and caps on how much they will lend in a personal loan. Typical personal loans range between $1,000 and $35,000, with some lenders offering much higher amounts to those with good or excellent credit. The average personal loan amount borrowed in 2018 was $10,575.

Term length: The term length is the amount of time the borrower has to pay the loan back. Personal loans usually have a fixed term, which means that all your monthly payments will be the same. Terms range from just a few months to six years or even longer. Three-year loans are the most popular, a LendingTree study found.

Prepayment penalties: Some loans come with the stipulation that you’ll be charged penalties if you pay the loan back entirely before the agreed-upon term is up. If you think you may want to pay your loan back faster than you are required to, it’s important to look at whether the loan you’re agreeing to has any prepayment penalties attached.

Other fees: Lenders can attach a variety of other types of fees to their personal loans, including origination fees and service charges. An origination fee is an amount you pay at the beginning of your loan for getting it set up; these fees usually range from 1% to 6% of your loan amount. It’s important that you read the fine print to know what fees you are responsible for once you sign on the dotted line.

Applying for a personal loan: An overview

Applying for a personal loan is generally a fairly pain-free process, especially if you work with an online lender that prioritizes speed (though be forewarned — such lenders often have higher rates and fees).

The fact that each lender structures its loans in its own way and offers customized rates means it’s a good idea to shop around a bit before settling on a lender. A good strategy is to get prequalified with a few lenders. Many lenders only do a soft credit pull for this process, which doesn’t affect your credit score.

Once you are ready to apply for a loan, lenders will want to get a better sense of your money management skills and financial situation in order to decide whether to lend to you. Typically, you will be asked to provide a variety of information about yourself as well as documentation. Here are some of the factors lenders will want to know about:

Credit score and credit history: When you make a formal application (as opposed to a prequalification request), the lender will do a hard credit check to learn about your credit score and history. Many lenders have specific credit scores they need to see in order to lend to an applicant. Those with high credit scores will be eligible for larger loans at better rates. Those with a longer credit history will also fare well in the lending process.
Employment and income: The lender may ask for information about your employment and income, including recent tax returns, pay stubs or W-2s. For obvious reasons, lenders will feel more confident lending to borrowers with a solid, steady income.

Debt-to-income ratio. A key metric that can predict your ability to pay back a loan is your debt-to-income ratio, which shows how much debt you carry in relation to your income. Lenders look for a ratio of 50% or lower, since that makes it more likely you’ll be in a good position to pay back your loans.
Some lenders also will ask for a phone consultation or in-person meeting after your initial application, though some online lenders will do the entire process digitally. Speaking to someone is useful for getting your questions answered and making sure you understand all the technicalities of the application and repayment process.

The amount of time it will take to get a loan offer varies across institutions. Banks typically take longer than online lenders, which can sometimes get you an offer within a day of your application and provide funds within a few days.

Conclusion

Personal loans are an extremely useful tool in certain circumstances, such as consolidating debt, financing big and necessary expenses and getting through an emergency situation. But it is important not to mistake personal loans for “free money” and underestimate the pressure you will find yourself under when the bills are due.

Take on personal loans with great hesitation, but once you’re sure it’s the right decision, shop assertively for the best terms available.

This article originally appeared in Student Loan hero, a media brand owned by Lending Tree.