A personal loan is a practical way to access a lump sum of money when you need it. Our extensive guide to personal loans will introduce you to the basics and show you important tips that will make the process of securing one easier for you.
You can use a personal loan for a variety of needs, including paying off more expensive credit cards, funding unexpected expenses, facing large bills, and consolidating other debts.
Personal loans 101
A personal loan is a simple tool to pay for the things you need when you don’t have the money readily available. While credit cards are an alternative to get funding, personal loans offer certain advantages that you won’t find with credit cards.
Personal loans come with a monthly payment that may be within your budget. This added predictability in your payments plus the fact that you’ll know the date when the loan will be paid off can help you manage your money better.
The amounts you can borrow range from $1,000 to north of $40,000—sometimes way north of that, depending on the lender, your credit profile and the purpose of the loan. Typically, you’ll get your funds within a few days of being approved, and rates are usually more attractive than those of credit cards.
At the lower end of the range, you can find quoted rates below 5% when you meet the lender’s conditions. These lower rates can help you save money if you want to consolidate debt—one of the more popular uses of personal loans.
Here’s a summary of important things you need to know about them:
A personal loan provides you with up-front cash that you repay over time according to a schedule. It amortizes and is repaid in installments. This means that by the time the loan matures, you’ll have paid it off in full through your monthly payments.
Your monthly payments will tend to be smaller the longer the loan’s maturity, and terms typically range from 24 to 60 months, though a few lenders market longer maturities.
How low of an interest rate you get and how long of a term you qualify for largely depends on your creditworthiness, which lenders will assess through their internal standards.
While important, your credit score won’t be the only metric they’ll use, so you may qualify for a loan even if your credit score needs some work.
Some lenders focus only on fixed rate loans, while others will give you the choice of fixed or variable rates. Regardless of your choice, you’ll notice that personal loans can be more competitive than most credit cards. This makes them increasingly popular among borrowers for refinancing more expensive debt.
Applying is simple
You can apply for a personal loan with a bank, credit union or online lender and the process to get one is simple. Be ready to provide details about your employment, income and residence. You’ll also need to provide other personal information such as your date of birth and contact number.
Soft credit pulls won’t hurt your credit
If you decide to check your rate, make sure you know ahead of time if the process will require an initial soft credit pull or a hard credit pull. That’s because hard credit pulls will reduce your credit score, while soft credit pulls won’t. Many lenders let you check your eligible rate online and will do so using a soft pull.
Out-of-pocket fees are not common
Many lenders charge an up-front origination fee that gets deducted from the amount you borrow so you don’t pay it out-of-pocket. If it applies, factor it into the loan to make sure your proceeds don’t fall short of the amount you need.
Other potential fees may include:
- Late fees—when you miss your due date by more than a certain number of days,
- Check-cashing fees—when you pay with a personal check and,
- Failed payment fees—when a payment fails because of insufficient funds in your account
You may run into lenders that charge prepayment fees. These are fees charged when you pay off your loan before it matures. While they’re not very common, look out for those lenders who still charge them and avoid them. In any case, make sure you read your loan terms and disclosures before you sign.
Types of personal loans
A personal loan could be right for you, but which type is better suited to your needs? Luckily, you can narrow down your options to some simple choices:
Secured vs. Unsecured
Personal loans can be secured or unsecured. Secured loans are backed by physical assets, a co-signer or both, while unsecured loans are backed only by your promise to repay them. You’re more likely to encounter unsecured personal loan offers during your personal loan shopping.
One big reason for that is their convenience. They’re faster to obtain, can be done from the comfort of your home, and are accessible to more people, since you don’t need to pledge any assets as collateral.
Variable or Fixed Rate
Personal loans can come with variable or fixed interest rates. Variable rate loans usually have a lower starting interest rate than their fixed rate counterparts. They have the potential to save you money if market rates don’t go up during the term of the loan.
» Monthly payments may change with a variable rate loan. That’s because variable rate loans are associated with an index that moves as market rates move around. They could be right for you if you’re looking for a shorter maturity loan. To be sure, you’ll need to have sufficient financial flexibility to face higher monthly payments should market rates increase.
» Monthly payments won’t change with a fixed rate loan. Fixed rate loans offer peace of mind. You don’t have to worry about your monthly payment potentially increasing during the life of the loan, even if market rates increase. With a fixed rate loan, you’ll have the same payment every month, adding predictability to your monthly budget.
Reduce your interest cost with a personal loan
Reducing your interest cost with new debt sounds counterintuitive, but you can do it with the right personal loan. If you qualify for a lower interest rate than what you currently pay, a personal loan could save you money.
For example, paying off credit card debt with a fixed rate loan can be advantageous over time if interest rates increase. If market rates were to rise, credit cards would adjust their interest rates higher and cost you more. But a fixed rate loan wouldn’t cost you more. Your rate and monthly payments would stay fixed.
Add predictability to your finances
By its very nature, a fixed rate personal loan will add discipline to your financial situation because you’ll need to make consistent monthly payments. And consistency can be a good thing if you’re serious about reducing your debt.
An added bonus is that you’ll know your payoff date ahead of time, which can help you stay focused and plan your finances accordingly. If you’re interested in lowering your debt faster, check out our Shed Debt Faster guide, where you’ll find additional tips to get to that goal.
Even if your credit score is less than perfect, you may still qualify for a personal loan. In some cases, you can qualify with a credit score in the low 600’s. If your score is too low, you may require a co-signer in order to qualify.
While a lower interest rate doesn’t guarantee that you’ll save money by refinancing with a loan, it’s still an essential requirement for you to see potential savings. As you’ll see in the section that follows, your payment behavior also plays a role in figuring out your savings.
Consolidating debt with a personal loan
When used to consolidate debt, a personal loan could save you money and ease your financial burden, but you’ll need to do some simple math to confirm your savings. An example will illustrate some of the things you should consider.
Let’s say you had two credit cards with an average rate of 18% on balances totaling $5,000. If you could get a 3-year personal loan with an 11% rate and no origination fee, would you say you’d save money by refinancing with the loan?
You’d think the answer is obvious, right? But it isn’t as clear-cut. To see why, we’ll take the above information and review two examples. We use our Pay off with a Loan calculator to simplify the math.
Example 1: Lower monthly payments on existing debt
In this case, suppose that you’ve been paying $150 every month to pay down your two credit cards. To simplify things, let’s say that you’re not making any new purchases or incurring fees.
Assuming the $5,000 loan comes without an origination fee, would you save money?
In this illustrative example, the results are mixed. The loan would reduce your total interest cost, but you’d tie up more cash every month since your monthly payment would go up. Such an outcome may work for you—or not. It’ll depend on your preference and financial situation.
Example 2: Higher monthly payments on existing debt
Now, consider an alternative situation. Suppose that you’ve been paying $200 every month to pay down your credit cards. You’re still carrying a balance of $5,000, but you want to pay it off sooner.
With the same loan terms as before, would you still save money?
In this example, you’d save on your total interest cost and you could lower your monthly payment too from $200 to $164. The loan to consolidate your credit card debt would make sense.
The takeaway here is that your payment behavior also plays a role in determining whether you’ll save money by refinancing with a loan. Take it into consideration when you review you loan terms to help you decide if you have a good deal.
Also, keep in mind that the illustrations above are representative examples which may not include all the factors you might wish to review. Your actual savings or cost may differ.
Qualifying for a personal loan
If you’re considering a personal loan, what do you need to qualify for one? Here’s our run-down:
Lenders will want to see you can pay them back
You’ll need to show potential lenders that you’re employed or otherwise earn sufficient income to meet their standards to offer you a loan. If you run into a lender who’ll offer you a loan without looking at your ability to pay them back, run away as fast as you can. It’s probably a scam.
Your debt-to-income is moderate
Your debt-to-income ratio is a number calculated by comparing how much you owe every month with how much you earn each month before paying taxes. It’s an important number for lenders because it gives them an idea of your existing financial commitments and ability to service their loan.
You’ll stand a better chance of getting a loan with a favorable rate if your debt-to-income ratio is below 50%. If it’s above that percentage, it doesn’t automatically disqualify you, but your terms may not be as attractive.
Your credit score is at least good
Lenders will look at your credit score as a snapshot of your credit history. What “good” means will change slightly from lender to lender, but a typical cutoff for good credit is when your score is 670 or better. In addition to a good number, lenders will want to see that you were able to maintain your score for a few years.
If you don’t have good credit, you can still get qualified for a loan by having a co-signer who does. Your co-signer is someone who agrees to be responsible for your loan if you end up being unable to repay it.
Impact of a personal loan on your credit score
If you get a personal loan to pay off your credit card debt, make sure you keep your credit card accounts open after you pay them off. By doing so, you’ll keep your credit utilization low and your credit card accounts will continue “aging.” That is, credit bureaus will keep reporting how long you’ve had the cards open in your credit history.
Also, the loan will diversify the types of credit you have—know as credit mix, which makes up part of your credit score. This increased mix can help.
The improvement won’t happen overnight, though. It’ll take a few months after you get the loan and pay off your credit cards or other debt you’re refinancing. You can find additional relevant information in our Beginner’s Guide to Understanding Credit Scores.
Also, as part of the approval process, lenders will eventually do a hard credit pull on your profile, which will have a temporary effect on your credit score.
Personal loans do’s and don’ts
Personal loans are a simple and convenient financial tool. To make the best out of them, keep an eye on these personal loans do’s and don’ts:
Make sure you can afford your monthly payments
You’ll start off on the wrong foot if your monthly payment isn’t within your budget. Be realistic and stick to a monthly payment you believe you can cover for the life of your loan.
Refinance if your situation improves
If you apply for a loan today, but your financial health improves later on, don’t forget to check potential savings by refinancing. You could get even better rates and save money, and most lenders won’t charge you a prepayment penalty.
Take action if you know you’ll miss a payment
If you know you’ll be late on your monthly payment, it’s better to contact your lender to work out a plan. With personal loans, your account is usually considered delinquent if you miss your due date. Take action to prevent negative reporting on your credit.
Don’t borrow more than what you need
If you qualify for more money than you need, resist the temptation of borrowing more. Larger loans may carry higher rates. Not only that, the larger monthly payments will restrict your available cash too, affecting your financial well-being.
Don’t embellish your loan application
Lenders have the right to verify the accuracy of the information you submit to them at any time. If you’re caught providing less than accurate information, your loan will likely be cancelled before it’s funded.
Unsecured personal loans offer fixed interest rates, a single monthly payment and a fixed repayment term. They’re increasingly popular among borrowers for refinancing more expensive debts, like credit card debt. And you can easily apply online and review multiple indicative offers.