Personal loans are installment loans, which means the borrower receives a lump sum from the lender and then repays it over a predetermined period. Providing the borrower chooses a reputable lender, these loans are relatively safe, predictable and unexciting (in a good way).
How Do Personal Loans Work?
Personal loans are offered by banks, credit unions, online lenders and other institutions. Interest rates and fees can vary widely among lenders, so it’s smart to compare preapproval offers from several lenders. Most lenders, including Discover, U.S. Bank and SoFi, let you check your personal loan rate without impacting your credit score. The majority of personal loans are unsecured and have fixed interest rates. But there are other options.
Secured or Unsecured?
Most personal loans are unsecured, which means they’re not tied to an asset used as collateral. However, consumers who want a secured personal loan shouldn’t have too much trouble finding one. And there’s a good reason to seek them out — lower interest rates.
“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.
However, not everyone wants to secure a loan with an asset. Some borrowers may not have an asset of high enough value or do not want to risk putting it up as collateral.
Variable or Fixed Rate?
Almost all personal loans have fixed interest rates and payments that don’t change. This makes budgeting easier because there are no surprise payment increases.
Variable-rate personal loans are much less common. Their interest rates and payments fluctuate with market conditions. If interest rates rise, the monthly payment will, too, potentially straining your finances. That can be especially painful if variable rates on other loans and cards increase at the same time.
“But borrowers may benefit if interest rates decrease,” says Markia Brown, a certified financial education instructor and registered financial associate. So borrowers must decide what they think might happen to interest rates during the term of the loan and whether they can manage the consequences if rates rise.
There is another consideration here. Fixed-rate personal loans have higher interest rates than the introductory rates of variable-rate loans. So, those who choose them might pay a higher-than-necessary annual percentage rate and miss out if general interest rates fall. In many cases, personal loans with variable rates are actually personal lines of credit, or PLOCs.
What Are Personal Loans Used For?
Here are some of the most popular uses for personal loans:
— Debt consolidation. Personal loans may have lower interest rates than what you’d pay with a credit card. And replacing credit card debt with installment debt like a personal loan lowers your credit utilization ratio, which can quickly improve your credit score.
— Home improvements. Create a more comfortable living space while increasing your property value. You won’t need an appraisal or any home equity to get approved for financing.
— Unexpected expenses. When your HVAC dies, the car breaks down or medical bills pile up, personal loans can quickly help you cover emergency costs and move on.
— Treats. You’re invited to a destination wedding, your kids have Disney vacation fantasies or you want to practice your Duolingo French — in France. Personal loans can help, but choose the shortest repayment term you can afford. Nobody wants to be paying for their honeymoon while planning their 10th anniversary party.
A personal loan can be a good way to pay for most needs and wants as long as you shop intelligently for your loan and budget carefully for its repayment.
What You Can’t Use a Personal Loan For
People tend to think of personal loans as all-purpose loans, meaning you can use the money for anything you like. However, some lenders impose restrictions, and no lender will oblige if you say you want the money for illegal purposes.
Lenders may restrict borrowing for a business or investments, gambling, educational expenses, and down payments tied to other loans. You can get into trouble if you use your loan for a prohibited purpose, so make sure that you and your lender are on the same page before committing to a personal loan.
What Is a Good Interest Rate?
What’s considered a good interest rate depends largely on your credit score. Personal loan APRs typically range from 6% to 35.99%, with the lowest rates reserved for borrowers with excellent credit, short loan terms and a low debt-to-income ratio. As of November 2024, the Federal Reserve Bank of St. Louis reported that the average rate on a 24-month personal loan from a commercial bank was 12.32%.
As you’re considering loan offers, focus on the APRs, which take into accountfees and interest and give you a better sense of the overall cost of the loan. As long as you’re comparing personal loans with the same repayment term, the loan with the lower APR is the better deal.
Pros and Cons of Personal Loans
How to Apply
The application process tends to be quick and easy. Unlike with some other types of loans, the money can often be in a borrower’s bank account within days, or even hours, rather than weeks or months.
Before beginning to shop for a loan, be sure to budget for the new payment and get financially fit. Even adding a few points to your credit score may get you into a better pricing tier.
Here are the steps to take when applying:
1. Request quotes or risk-free preapprovals, which only require a “soft” credit pull, from several lenders. People are often surprised by the differences between the loans on offer.
2. Once you’ve chosen the lender with the best deal, follow its application process. Many borrowers apply online or by phone. You can also can visit a local bank or credit union branch if you prefer a personal touch. Never lie when completing an application. It’s fraud and can land the offender in jail.
3. Expect to provide a government-issued photo ID and proof of citizenship or residency status. Lenders can also request bank statements, tax returns, pay stubs and other paperwork. You can often upload these documents online or via the lender’s app.
4. Be sure you understand the loan’s terms. “Carefully review the loan agreement, including fees, penalties and repayment terms before signing,” Brown says.
Applicants may get a decision on the same day they apply and receive the funds the following business day, depending on the lender. If fast access is important, make sure the lender offers it before you apply.
Don’t be put off by this list. Most lenders pride themselves on their quick, no-fuss service. Unless a lender has reason to be suspicious or the borrower wants a very large sum, most applications are hassle-free.
How Loans Impact Your Credit
Personal loans can affect your credit score in several ways:
— While getting rate quotes and preapprovals generally doesn’t affect your credit score, a formal loan application does. The lender will pull your credit report and generate a hard inquiry, which can drop your credit score by a few points.
— Adding a new loan to your credit report can lower your score because it decreases the average age of your accounts and increases your outstanding balances.
— However, using a personal loan to consolidate credit card debt can have an immediate, positive effect on your credit score. Revolving balances like credit card accounts increase credit utilization, which makes up 30% of your FICO credit score. Replacing that revolving debt with installment debt, like a personal loan, lowers credit utilization.
— If you only have revolving accounts like credit card balances, adding an installment loan improves your mix of credit, which comprises 10% of your credit score.
— Paying down your personal loan balance with on-time monthly payments creates good repayment history, which impacts 35% of your credit score.
Strategies for Paying Back the Loan
Before committing to any loan, check your budget and make sure you can comfortably cover the monthly payments.
Here are some tips for paying off your loan once you have it:
— Make larger payments than required. Any extra amount will help. But first, check your loan agreement for prepayment penalties, which can cut into potential savings.
— Revise your household budget. Redirect any savings you find toward early repayment.
— Use auto pay. This ensures every payment is timely and could save you late fees. You might also get a small discount on your interest rate.
As you’re repaying your loan, resist the urge to tap into your emergency fund. Otherwise, an unexpected expense could plunge you into more debt.
Alternatives to Personal Loans
For many, a personal loan is a good way to borrow. However, it’s worth considering other options:
— Borrowing from family. This can be the least costly way to borrow. But it involves putting life’s most valuable relationships at risk if the loan goes bad.
— Credit cards. Credit cards allow you to quickly access credit. That said, they can have sky-high interest rates, and the temptation of minimum payments can be ruinous.
— Home equity loans. Open only to homeowners with enough equity to qualify, these loans are secured by your home. They’re not the fastest source of credit, and they have closing costs. However, home equity loans can be less expensive than personal loans, especially for larger amounts.
— Home equity lines of credit, or HELOCs. These are also secured by real estate and open only to homeowners with equity. They’re a bit like credit cards in that you get a credit limit and can borrow, repay and borrow again up to your limit.
More from U.S. News
How to Get a Low Interest Rate on a Personal Loan
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Can You Get a Personal Loan When You’re Self-Employed?
How Do Personal Loans Work? originally appeared on usnews.com
Update 01/24/25: null