Personal loans offer many benefits over credit cards and are the fastest-growing type of consumer debt. Here's what you need to know.
- When it comes to taking out loans, the devil is in the details.
- Understand the basics of what personal loans are and how they work.
- Learn how using a personal loan can raise your credit score.
- Know what questions to ask so you can find find the best personal loan.
- Understand your options and decide which type of loan is best for you.
Although nobody wants to go into debt, everybody experiences times in life when some extra cash would be useful. In these times, borrowing money may be an option to consider.
Perhaps your home desperately needs a new roof, or your daughter is getting married. Maybe you need to consolidate debt, or you’re trying to make a business opportunity work.
In some cases, borrowing money is the only option.
In others, you might want to leverage credit strategically so you don't have to put your own assets on the line.
Either way, it's best to proceed with caution before taking on any new debt. For better or worse, a single borrowing decision can have consequences for your wealth plan for the rest of your life.
Here, we'll walk you through everything you need to know about personal loans, one of the most flexible borrowing options for these kinds of “financial odds and ends”. Armed with this information, you can make an informed decision about whether you want to compare and apply for a personal loan to meet your financing needs or look elsewhere.
What's The Benefit of Obtaining a Personal Loan?
Personal loans are unsecured installment loans with a fixed interest rate and term that can help you pay for just about anything over time with affordable monthly payments.
Unlike borrowing against your home or vehicle, taking out a personal loan won't put your other property at risk. And, unlike credit cards, you cannot keep borrowing against a personal loan — funds are disbursed once and you repay the loan with fixed monthly payments.
Personal loans are now the fastest-growing type of consumer debt, for good reason. The loans can be used for nearly anything and offer decent interest rates, and fair approval standards for many types of consumers.
However, as with any financial product, the devil is in the details. Not all personal loans are created equally, and you must understand exactly what you’re getting into before you sign on the dotted line.
A personal loan is an unsecured loan, which means it’s not backed by any collateral. When you take out a personal loan, you don’t have to put up your home, car, or anything else that you could lose if you were to default. It’s also an installment loan, meaning it has a fixed interest rate and requires you to make regular monthly payments.
Unlike credit cards, which allow you to take as long as you want to repay the loan (as long as you make the minimum payments), personal loans have a fixed repayment term. Once you pay your loan in full, your account is closed. If you want to borrow more money, you’ll need to reapply for a new loan. These factors make personal loans less risky for lenders, so they often offer well-qualified customers a lower interest rate than credit cards.
What Can You Do with a Personal Loan?
One of the biggest benefits to personal loans is that once you’re approved, you can use the funds for virtually any purpose.
Some of the reasons people take out personal loans include:
- Financing a home remodel or upgrade
- Starting a new business
- Paying for auto expenses
- Covering medical expenses
- Helping out a loved one
- Covering funeral expenses
- Paying for a wedding or special event
- Any other major purchase
Another common reason that people take out personal loans is to consolidate high-interest-rate credit card debt.
When used correctly in this way, personal loans can be a powerful tool to get out of debt faster.
What Kind of Credit Score Do You Need for a Personal Loan?
Personal loans require a fixed monthly payment but no collateral, so credit requirements for the lowest-rate personal loans may be even more stringent than auto loans or credit cards.
Less-qualified borrowers may still be able to get a personal loan, but interest rates become prohibitively expensive for borrowers with below-average credit scores.
As with any credit application, lenders will evaluate your credit history and your income.
While every lender varies, in general, applicants with credit scores of 750 or higher may qualify for the best interest rates. Lenders definitely want to see a credit score of no less than 600. Applicants with scores above 600 but below 700 may have a harder time getting a loan with some lenders, but be approved with others.
If you're considering applying for a personal loan, this is the perfect time to check your credit score. If you find that it's less-than-ideal, you may want to consider foregoing new debt and instead focus on taking steps to reduce existing debt and improve your creditworthiness.
When applying for a personal loan, lenders also pay particularly close attention to your debt-to-income ratio.
Your debt-to-income ratio is calculated as:
The sum of your monthly debt payments (mortgage payment, loan payments, and minimum credit card payments) divided by your gross monthly income.
For example, if you owed $1,000 towards debts each month on a gross monthly income of $5,000, you would have a debt-to-income ratio of 0.2 or 20%.
Your debt-to-income ratio is important because it shows the lender your ability to afford the new debt payment. If, for example, taking out a personal loan would cause your debt-to-income ratio to exceed 50%, it's very unlikely the lender would approve the application because they know, after taxes and debt payments, you have very little income left for essential living expenses.
Savvy consumers want to keep their debt-to-income ratios as low as possible, but lenders may permit up ratios of up to 40 to 45%. This is a “just because you could, doesn't mean you should” situation.
The exception is if you are taking out a personal loan to consolidate debt. In this case, your application may show your debt-t0-income ratio rising dangerously high, but, in reality, your new personal loan payment will replace other debt payments, and your ratio may either stay the same or decline. If, however, your ratio is hovering around the lender's cut-off line, it can make it difficult to get approved for the new loan.
Secured Personal Loans
A few lenders offer secured personal loans, also known as collateral loans.
These loans are secured by deposits in a savings account or certificate of deposit.
Secured personal loans can make sense if:
- Unsecured loan interest rates are prohibitively high
- You're trying to build or rebuild a positive credit history
- You need to borrow a large amount of money and have the assets to offer as collateral
How Much Can I Borrow?
Loan amounts vary by lender, but you can often find personal loans for amounts ranging between $1,000 and $35,000.
On average, people who take out personal loans borrow between $5,000 and $15,000. A few lenders will offer personal loans up to $50,000 or even $100,000.
The more money you want to borrow, the more stringent the lender will be when evaluating your application.
In most cases, you’ll have anywhere between 12 and 84 months (one and seven years) to repay the loan, with the most popular terms being 36 and 60 months (three and five years).
Before you commit to a loan, it’s important to understand the terms. This includes your interest rate, repayment period, and your monthly payment.
If you’re not 100 percent sure you have sufficient cash flow to make the monthly payments, then opt for a longer repayment period or do not take out the loan. In general, a repayment period of 24 to 36 months (two or three years) is ideal.
Choose anything longer than that and you’ll end up shelling out far too much in interest payments.
Related: Personal loan calculator
Use our personal loan calculator to figure your monthly payment and total interest cost for different loan amounts, terms, and interest rates.
How Do Personal Loans Impact Your Credit Score?
You may also wonder how a personal loan will impact your credit score. The answer to this question depends on what you’re using the loan for, how much other debt you have, and whether you make all of your payments on time.
If you’re using a personal loan for a purchase, then the extra debt may pull your credit score down a little bit. However, it won’t have as much of a negative impact as using a credit card that’s close to its limit.
Using a personal loan to consolidate higher-interest-rate debt is actually likely to raise your credit score. Of course, that’s assuming that you make all of your payments on time.
If raising your credit score is one of your goals, you’ll want to make it a point to pay more than your required payment each month so you can bring your total amount of outstanding debt down as quickly as possible.
It’s also critical that you don’t run up new balances on the credit cards you’ve just paid off. Otherwise, you’ll find yourself carrying twice as much debt and will have fewer options for digging yourself out the second time around.
Where Can I Find the Best Lenders?
Any time you borrow money, it pays to shop around, and personal loans are no exception. You can get a personal loan from a bank, credit union, personal finance company, online direct lender, or even peer-to-peer lenders.
We have a list of some of the best direct personal loan lenders here.
Credit unions often offer personal loans with the largest benefits like the lowest interest rates, while online direct lenders are usually your best bet for faster approval times. They may also be more willing to accept borrowers with less-than-perfect credit.
We offer two ways to help you find the best personal loan for your needs.
The widget below will show you the best personal loan lenders available in your, state as compiled by Consumers Advocate.
Alternately, LendingTree can show you the best interest rates for which you'll qualify from different lenders after you answer a few questions. (Taking this step is not the same as applying for a loan, so it will not impact your credit score.) Check your rates now.
When you’re shopping for a loan, you’ll want to compare the basics, like the interest rate and required payment period, but there are other important things to consider. Before you make your final decision, ask each potential lender the following three questions.
1. How Long Will It Take Before I Receive My Money?
If you need cash fast, this is a very important question. You’ll want to know how long it will take for you to receive your loan approval, and also how long after the approval you’ll receive your money.
While most lenders will give you an answer within a few days to a few weeks, some will evaluate your application and give you an answer on the spot. You’re more likely to find this feature with direct online lenders. Some lenders will also transfer the money to your bank account within a few hours after approval, while others will require you to wait a few days or even longer.
2. Are There Any Prepayment Penalties Associated with This Loan?
When you take out your loan, you’ll usually have the option to choose your repayment period. If you find that you have extra cash later on, it can make sense to pay your loan off early so you can save money on interest payments.
However, some lenders charge a prepayment penalty. You’ll want to find out about this before you take out the loan. There are many great lenders that don’t charge prepayment penalties, so there’s rarely a reason to work with one that does.
3. How Much Are the Loan Origination Fees?
Another fee you’ll want to make sure you’re aware of is the loan origination fee. This is an extra cost added to your loan to cover the lender’s expenses for setting it up. This fee can range anywhere from 1 to 8 percent of the loan amount. It’s typically charged upfront and deducted from the cash you’ll receive.
So, for example, if you borrowed $10,000 and had a 5 percent origination fee, the lender would keep $500 and you would receive $9,500. You’ll want to take this into consideration and make sure you take out a loan large enough to cover your need after deducting the fee.
Some lenders don’t charge an origination fee, but that doesn’t mean you’re not paying for these costs. In this case, they usually make up for it by offering you a higher interest rate.
It’s important to review this information carefully and take the time to do the math. While one lender’s offer may initially seem like a better deal, when you add in all the fees and costs, you could end up paying more in total.
A good lender will give you all of this information up front and will be completely transparent about their fees. Remember to always trust your gut. If you don’t feel good about the way a lender is conducting business, move on. You have plenty of choices, and since you’ll be dealing with the lender for at least a few years, it’s important to watch for any red flags before you make the commitment.
How Do I Apply for a Personal Loan?
Another benefit of personal loans is that most lenders allow you to complete the entire loan application process online. You’ll need to fill out your personal information and provide details like the name of your employer and your annual income. You may need to provide a copy of your identification and paperwork to verify your income, like your W2, paystub, or tax return.
Once the lender has reviewed your application, they’ll let you know whether you’re approved. At this point, you can review the details, like the interest rate and payment terms, and decide whether you would like to accept the loan. If you decide to move forward, you’ll sign a promissory note and receive the funds. Then, you’ll receive a bill each month for your payment due.
Is a Personal Loan the Best Choice for Me?
When you’re thinking about borrowing money, credit cards and home equity loans are usually the first things that come to mind. However, in most cases, personal loans offer benefits that make them preferable to both of these options.
Although credit cards are generally quick and easy, they’re usually not the best solution. The average credit card interest rate is currently between 16.94% and 23.94%. The flexibility to pay only a small minimum monthly payment might seem attractive, but, in the end, doing so will cause you to pay a ridiculous amount of interest. Since you also have the option to keep using the card for additional purchases, there’s a greater chance that you could continue to rack up debt until it becomes unmanageable.
If you have excellent credit, you may be able to get a credit card with a zero-percent introductory interest rate. If you’re sure you can pay the balance in full before that rate expires and you trust yourself not to make any additional charges, then a credit card could be a good idea. However, unless all of these factors are certain, a personal loan is usually still your best bet.
Credit cards are useful for making small purchases while personal loans are better for borrowing larger amounts. If you need something that’s a few hundred dollars, using a credit card is usually fine. However, if you need more than $1,000 and/or you need more than 15 months to repay the balance, then you’re likely better off with a personal loan.
Home equity loans or lines of credit are another option for you to consider. These loans use your home as collateral. The amount you can borrow is based on the difference between your home’s current value and the total amount you still owe on your mortgage and other equity loans you’ve taken against it.
When you apply for a home equity loan, you’ll have to go through the same process you did when you applied for a mortgage. This includes paying for a home appraisal. While the interest rate is likely to be less than what you’ll pay for a personal loan, you’ll have to pay fees and closing costs.
When you take out a home equity loan or line of credit, there’s a chance that you could lose your home if you find yourself unable to pay it back. Since these loans often have a much longer repayment period, typically five to thirty years, you’ll also end up paying more in total interest over the life of the loan. Unless you need to borrow a significant amount of money and you need a long time to pay it back, an equity loan almost always isn’t worth the hassle and extra expense.
The Bottom Line
If you want to build a sound financial future, it’s best to avoid consumer debt whenever possible. That’s why we’re huge proponents of saving as much as you can and ensuring that you have an emergency fund in place.
However, sometimes things happen whether you’ve saved for them or not. If you find yourself in a serious pinch, a the benefits of a personal loan may out-weigh their drawbacks when compared to other types of financing. Now that you understand all of the most important questions to ask before committing to a loan, you’re in the best possible position to choose the ideal loan for your needs.