If you need to borrow money for debt consolidation, home improvements or just about any other big-ticket expense, a personal loan can provide the financing you need. However, there are a few different types of personal loans — each with different benefits and drawbacks — depending on your exact needs.
So if you’re in the market, it’s a good idea to learn the ins and outs of how different types of personal loans work.
Secured Personal Loan
Unsecured Personal Loan
Debt Consolidation Loan
Personal Line of Credit (PLOC)
Types of Personal Loans
There are many types of personal loans, but these are some of the most common options available.
Secured Personal Loan
A secured loan uses collateral, such as a bank account, vehicle or property, to back the amount of money borrowed. Secured loans typically offer a fixed interest rate and fixed payment amount for a set number of months.
“Secured loans are easier to obtain and thus, are well-suited for people with tarnished credit,” says Andrea Mosher, senior vice president of lending at Lake Trust Credit Union. “In addition, secured loans often have a lower interest rate in comparison to unsecured loans, making it a good option for people with tight budgets.”
On the other hand, Mosher points out that one downside of secured loans is that, if a borrower stops making payments, lenders can seize the collateral that was used to secure the loan. Borrowers may also be required to obtain insurance on the collateral to protect the lender in the event of total loss, though this often depends on the size of the loan.
Unsecured Personal Loan
Also known as a signature loan, unsecured loans do not require any type of collateral to obtain. Like secured loans, these loans typically offer a fixed interest rate and fixed payment amount for a set number of months. Mosher notes that unsecured loans are considered riskier for the lender since there’s no asset that can be repossessed, so they typically have higher interest rates.
“Lenders solely evaluate a borrower’s creditworthiness for approval, so they are not necessarily a good option for people with poor or low credit scores,” Mosher says. “If a borrower defaults on an unsecured loan, lenders may commission a collection agency to collect the debt or take the borrower to court.”
On the plus side, borrowers may get their funds more quickly because the loan application doesn’t require additional steps for verifying collateral.
[Read: Best Personal Loans.]
Debt Consolidation Loan
Luke Seely is a certified financial planner and chartered financial consultant at Brightside, a financial care platform for employers. According to Seely, a debt consolidation loan
is a personal loan that’s used for the specific purpose of pooling together multiple outstanding debts — with different APRs and terms — into one large loan with a single fixed, monthly payment.
The main advantage to this type of personal loan is that you can reduce the average rate you’re paying on debt, especially if you use the loan to consolidate high-interest debts like credit cards. You also have just one monthly payment to manage, reducing the likelihood that you’ll forget about a due date and miss a payment. Plus, debt consolidation loans come with fixed rates and are paid in equal installments over a few years, which can make your payments more predictable and easier to fit into your budget.
That said, if you don’t have strong credit, you may not qualify for a very competitive interest rate.
Personal Line of Credit (PLOC)
is a set amount of funds that can be borrowed against as needed, up to the limit. Mosher explains that the balance on a personal line of credit increases each time a borrower draws from the line, reducing the remaining credit available. Interest is also charged on the portion of the balance you use.
“Borrowers can return to their original available credit by repaying the principal balance on their PLOC,” she says.
Mosher adds that PLOCs are a good option for people who want to borrow funds on an ongoing basis or want to have a source of emergency funds available.
“Additionally, some lenders will allow borrowers to use their PLOC as a form of overdraft protection,” she says. “One downside, however, is that rates are typically variable and change over time, making it more difficult to predict the monthly payment amount.”
How to Choose the Best Personal Loan
Once you’re ready to get a personal loan, follow these steps to ensure you choose the right one for your needs.
Assess Your Financial Needs.
First, consider why you want a personal loan and how much you need to borrow. It’s important to borrow enough so that your expenses are fully covered — but not too much, which could result in paying extra interest for no reason. Also consider whether a personal loan is the most appropriate financing option for your situation, or if other types of loans (such as a home equity loan, auto loan, etc.) might be better suited to your needs.
Check Your Credit Score.
Your credit score plays a significant role in determining the interest rates and terms you’ll be offered, so it’s important to double-check that your credit history and score are in good shape before applying.
You can pull a copy of your credit reports at annualcreditreport.com. Review your reports from all three major credit bureaus to ensure they’re accurate. You may also be able to see your FICO score for free via your bank, credit union or credit card issuer. If necessary, take steps to improve your credit before applying for a loan so you can qualify for the best offers.
[Read: Best Credit Cards.]
Research Lenders.
Next, compile a list of potential lenders, including banks, credit unions and online lenders. Look for those that offer personal loans for the purpose you need and cater to borrowers with your credit profile. You should also check ratings and customer reviews on sites such as Better Business Bureau
and TrustPilot to ensure they offer helpful customer service and resolve issues promptly.
Compare Interest Rates, Fees and Terms.
Once you have a few lenders in mind, compare the loan rates, fees and terms available from each. Many lenders will allow you to get a free quote online by sharing a few personal details, which won’t impact your credit. Also look for additional loan features, such as flexible repayment terms, the option to make extra payments without penalty or the availability of a co-signer option. Once you find an offer that meets your needs, you can submit an official application.
Pros and Cons of Getting a Personal Loan
While personal loans can be a helpful financial tool for some borrowers, there are also some disadvantages when compared to other borrowing options. So before pursuing a personal loan, consider these pros and cons.
Pros
— Flexibility: Personal loans can be used for a wide range of purposes, from debt consolidation and home improvements to medical expenses and travel. This makes them a versatile borrowing option compared to other types of loans, which may have more specific uses (e.g., mortgages for home purchases or auto loans for car purchases).
— May not need collateral: Many personal loans are unsecured, meaning they don’t require collateral — particularly for borrowers with good credit. This can be advantageous if you don’t want to risk losing an asset in case you’re unable to pay back your loan.
— Fixed interest rates and payments: Personal loans come with fixed interest rates and monthly payments, which can provide more predictability and stability for your budget and cash flow.
— Potentially lower interest rates: Depending on your credit score and financial situation, personal loans tend to offer lower interest rates than credit cards or other forms of high-interest debt. This can save money and help pay off your debt faster.
[READ Best HELOC Lenders]
Cons
— Fees: Personal loans can come with various fees, such as origination fees, prepayment penalties or late payment fees. These can add to the overall cost of the loan, making it less attractive compared to other borrowing options that may have fewer or lower fees.
— Limited borrowing amount: Personal loans typically have lower borrowing limits than other types of loans, like mortgages or HELOCs. This means that if you need to borrow a large sum of money, a personal loan may not be the best option.
— May require collateral: If your credit isn’t in great shape, or you want to qualify for a lower interest rate and/or larger loan amount, you may be required to put up collateral. There is always a risk of losing your collateral if you default on the loan.
— Some borrowing exclusions: Even though a personal loan can be used for almost any purpose, most lenders do impose some restrictions. For instance, you usually can’t use a personal loan to invest or pay for college.
Personal Loans to Avoid
It’s important to note that some types of personal loans should be avoided due to their excessive costs and lack of borrower protections. When shopping around, steer clear of these:
— Payday loans. Payday loans are short-term, high-interest loans typically meant to be repaid on your next payday. They often come with extremely high interest rates (sometimes up to 400% APR or more) and fees, making them one of the most expensive borrowing options available. These loans can quickly lead to a cycle of debt if you’re unable to repay them on time.
— No-credit-check loans. Some lenders offer personal loans without checking your credit, which might seem appealing if your score isn’t so great. However, these loans often come with high interest rates and fees, as well as unfavorable terms, since the lender assumes a higher risk by not evaluating your credit history.
— Title loans. A title loan is a type of secured loan for which you use your vehicle’s title as collateral. These loans often have high interest rates, fees, and short repayment terms, making them risky and expensive. If you’re unable to repay the loan, the lender has the right to repossess your vehicle.
— Long-term, high-interest loans. While a longer repayment term might seem appealing due to lower monthly payments, it can result in significantly higher overall costs if the interest rate is high. Be cautious of loans with lengthy repayment terms and high interest rates, as you may end up paying much more than you initially borrowed.
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