Personal loans are one way to get financing for a major expense, often at an affordable rate compared to credit cards and other high-interest borrowing options. However, before you get too deep into researching the best personal loan lenders, make sure you understand how a personal loan works and whether it’s the right choice.
What is a Personal Loan and What is it Used For?
A personal loan is a type of loan that can be used for a variety of purposes. They’re offered by banks, credit unions and specialized online lenders.
Some of the most common reasons people take out a personal loan include consolidating debt, financing home improvements or covering a big-ticket purchase. Borrowers may also use a personal loan to pay for a wedding, vacation, major medical procedure or almost any other major expense.
That said, you can’t use a personal loan for absolutely any purpose. Lenders have their own policies and criteria for determining what expenses they will allow borrowers to use personal loans for but, generally, personal loans may not cover:
— Business expenses. As the name suggests, personal loans are intended for personal use only. If you need financing for business expenses, you should consider a business loan instead.
— Investments. Personal loans generally cannot be used to invest in stocks, bonds or other financial instruments.
— Education expenses. Most lenders don’t allow borrowers to use personal loans to cover college costs, including tuition. Even if some do, students are usually better off pursuing other options, such as federal student loans.
— Down payments. Personal loans are typically not used to make down payments on mortgages, auto loans and other types of financing.
— Illegal activities. This might not come as a surprise, but lenders won’t approve a loan for any purpose that is illegal or fraudulent.
[Read: Best Personal Loans.]
Types of Personal Loans
There are different types of personal loans available, and the kind you need will depend on your particular goal and financial situation. In general, you’ll find a couple of common options to choose from.
Secured vs. Unsecured
Some personal loans are secured, meaning they require collateral (such as a bank account, vehicle or real estate) in order to qualify. The collateral used to secure the loan serves as a guarantee to the lender that they will be repaid even if you’re unable to make payments. If you default on the loan, the lender has the right to seize the collateral to recoup their losses.
“Secured loans generally have lower interest rates due to reduced lender risk,” says Markia Brown, a certified financial education instructor and registered financial associate.
An unsecured personal loan is not backed by collateral. Instead, the loan is approved solely based on the borrower’s creditworthiness and ability to repay the loan.
“Because unsecured loans don’t require collateral, they are viewed as riskier and may have a higher interest rate to offset this risk,” says Gabe Krajicek, CEO of Kasasa.
Lenders may also have more strict eligibility requirements, such as a higher credit score or income, and you may not be able to borrow as much. If you default on an unsecured personal loan, the lender may take legal action to recover the funds since there’s no collateral to seize.
Fixed vs. Variable Rate
Another important distinction when it comes to personal loans is whether the interest rate is fixed or variable.
With a fixed-rate personal loan, the interest rate stays the same throughout the life of the loan. This means you’ll pay the same amount of interest each month, regardless of any changes in market conditions. Fixed-rate loans offer predictable payments and are a good option if you prefer the security of knowing exactly how much you will owe each month. “This can help borrowers budget more effectively,” Brown says.
A variable interest rate, on the other hand, can change over time based on fluctuations in the market or changes to the benchmark rate. This means your monthly payment can vary over time, making it more difficult to budget for payments. Variable-rate personal loans may offer lower initial interest rates compared to fixed-rate loans, but they also come with more uncertainty. “But borrowers may benefit if interest rates decrease,” Brown notes.
[Read: Best 0% APR Credit Cards.]
Requirements to Get Approved for a Personal Loan
The specific requirements to get approved for a personal loan can vary depending on the specific lender, loan amount and whether or not collateral is needed. However, there are some general qualifications that most lenders will consider when evaluating your application, including:
— Credit score. Your credit score is often one of the most important factors that a lender will consider. Brown notes that higher credit scores usually result in better interest rates and loan terms. Generally, you’ll need a score of at least 670 to qualify for the best rates, though some lenders might require an even higher score.
— Income. You’ll also need to show proof of income, such as pay stubs or tax returns, to prove you have the means to repay the loan. Lenders often have a minimum income requirement as well. Lending Point, for example, requires borrowers to earn a minimum of $35,000 annually to get a loan, while Discover requires a minimum income of $25,000 per year to qualify.
— Debt-to-income ratio. Lenders may also evaluate your debt-to-income ratio (DTI), which measures the amount of your gross income that goes toward repaying debt. A lower debt-to-income ratio may improve the chances of getting approved for a loan, with a DTI of less than 36% being ideal.
— Employment history. Some lenders may require proof of stable employment, such as a certain number of years with the same employer, to demonstrate that you have a reliable source of income.
— Citizenship or residency status. You’ll need to provide proof of citizenship or residency status, which ensures you are legally allowed to borrow and repay a loan.
— Age. Borrowers must typically be at least 18 years old to apply for a personal loan.
Again, the specific requirements for a personal loan will vary. When shopping around, be sure to review the lender’s requirements and compare multiple options before applying.
Pros and Cons of Personal Loans
Personal loans can be a useful financial tool for many people, but they also come with drawbacks. Here are some pros and cons to consider:
Pros
— Flexibility. Brown says that one of the biggest benefits of personal loans is the flexibility, as they can be used for various purposes. In other words, borrowers can often use the funds as they see fit.
— Lower interest rates. Your credit score will impact the interest rates you qualify for but, in general, personal loans come with lower rates than other popular borrowing options such as credit cards.
— Fixed payments. If you opt for a fixed-rate loan, your payments will remain the same throughout the life of the loan. This can help you budget and plan for the future.
— Collateral not required. Many personal loans are unsecured, meaning you don’t have to put up any assets to secure the loan if you prefer not to.
— Quick access to funds. Personal loans can often be approved and funded quickly — often in less than a week.
— Builds credit. Personal loans also help build credit, Krajicek says, so long as payments are made in full and on time. “This is especially beneficial for younger generations just starting out on their credit journey,” he notes.
Cons
— Fees. Interest may not be the only expense you need to worry about. “Some personal loans may have origination fees, prepayment penalties or late payment fees, increasing the overall cost of borrowing,” Brown says.
— Shorter repayment terms. Personal loans typically come with fixed repayment terms that last two to five years, which can be a disadvantage if you need more time to pay back the loan. Additionally, most personal loans are installment loans, which may not be ideal if you need a revolving line of credit to borrow against as needed.
— Impact on credit score. Taking out a personal loan increases your overall debt, Brown notes, which can temporarily lower your credit score. That may be a concern if you’re looking to take out another loan in the near future, such as a mortgage.
[Read: Best Home Equity Loans.]
Should You Take Out a Personal Loan?
Overall, a personal loan can be a good option if you need to borrow money for a specific purpose. They typically have lower interest rates than credit cards, and you can often borrow a larger amount of money.
That said, you may want to consider other options first. For instance, if you need a personal loan to consolidate debt, look into whether you can negotiate with creditors or take advantage of credit counseling before taking on more debt. If you’re looking for low-interest financing, it may be a good idea to compare similar options before making a decision — such as a home equity loan or line of credit.
And if you do decide to pursue a personal loan, always read the fine print. “Carefully review the loan agreement, including fees, penalties and repayment terms, before signing,” Brown says.
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How Do Personal Loans Work? originally appeared on usnews.com
