A personal loan can be an excellent way to consolidate debts or cover expenses without having to put up any of your assets as collateral. Plenty of companies offer personal loans -- each with their own pros and cons. Further, interest rates and other loan terms can vary significantly among lenders, so here are a few things you should know before you start shopping.
Loan vs. line of credit
A personal loan generally involves borrowing a certain amount of money and paying the balance back over a set amount of time at a fixed interest rate. The main advantage of a personal loan is that you know exactly how much you borrowed and how much you'll have to pay back, including interest.
If you'd like a little more flexibility, you may want to consider a personal line of credit instead. With a line of credit, you'll have access to a certain amount of money which you can borrow at any time you'd like. Much like a credit card, you can take out as much or as little as you want from the line of credit as long as you don't exceed the maximum amount. Also like a credit card, you only have to pay back what you use. The repayment arrangements tend to be more flexible than those of loans, but the interest rates are variable. So if you tap into your line of credit, and market interest rates subsequently rise, then you could see your interest payments climb as well.
A line of credit might be a good idea if you know you'll need to borrow money but don't know a precise amount. For example, if you're doing some renovation projects around your house and estimate the cost to be somewhere between $5,000 and $10,000, a line of credit gives you the flexibility to borrow only as much as you need to. On the other hand, if you know exactly how much money you need, a loan could be the better choice because of the stable interest.
Banks vs. P2P lenders
The two most popular options for personal loans are banks and peer-to-peer (P2P) lenders. If you want a line of credit, you'll probably be limited to banks.
Peer-to-peer lending is a relatively new industry, and it has grown rapidly with companies such as Lending Club and Prosper. The basic idea is that regular people (investors) fund loans for their "peers," and the borrowers' payments are distributed to investors.
Generally, banks only give personal loans to customers with excellent credit, but most P2P lenders offer loans to subprime borrowers. Because P2P loans are funded by people (not banks), it's up to the individual investors to decide which loans they want to take a risk on.
However, keep an eye on the fees charged by P2P lenders. Although they're generally transparent and easy to understand, they can be significantly higher than those charged by banks. As an example, Lending Club charges an origination fee equal to 1%-5% of the loan amount which is deducted from your loan proceeds, while Wells Fargo charges no origination fees whatsoever on personal loans. This is only one piece of the puzzle, but it's definitely a major factor to consider. After all, a 4% origination fee means that if you need $10,000, you'll actually need to take out a loan for more.
How much do you need to borrow?
When shopping for lenders, bear in mind that different banks and P2P lenders set their own maximums and minimums. While Wells Fargo requires a minimum of $3,000 for personal loans, Lending Club will fund loans as low as $1,000. On the other side, Lending Club offers loans as high as $35,000, but Wells Fargo will consider personal loans of up to $100,000.
|Lender||Minimum loan||Maximum loan|
This is just a sampling of some of the more popular personal lenders. Be sure to check several lenders' minimums and maximums while shopping to help narrow down your options.
Rates, terms, and other loan factors
Most major personal lenders (banks and P2P) have roughly the same range of interest rates. On the low end, borrowers with the best credit generally get rates around 6%, while the riskiest borrowers may be charged rates as high as 30%-35%.
Most of us will fall somewhere in the middle of this group. However, because each P2P lender uses its own proprietary method for assigning credit risk, the rates you're offered can vary significantly. Most P2P lenders allow you to get a rate quote without affecting your credit score, so it pays to shop around.
To illustrate this, I obtained quotes from both Prosper and Lending Club for a hypothetical $10,000 loan with a 36-month term. After I submitted some basic information, Lending Club offered me a 7.89% interest rate and a 3% origination fee, while Prosper's offer carried a much higher interest rate of more than 15%. I'm not sure what Prosper saw that Lending Club didn't -- I filled the same information into both forms -- but the lenders' proprietary risk-assessment models returned two completely different results.
Another thing to consider is the length of the loan. Most lenders offer loans of 36 to 60 months in duration, but if you'd prefer a longer time frame, there are some options out there. For example, Discover Personal Loans offers terms as long as 84 months.
Finally, although I'm a big fan of the peer-to-peer lending business model, I always encourage people to start their search at their own bank, at least to establish a good basis for comparison. Many banks offer special discounts for customers who have a pre-existing relationship, so your bank might offer you a better overall deal. For example, Wells Fargo (my bank) quoted me 8.255% on the same $10,000, 36-month loan, and while Lending Club's interest rate is lower, Wells Fargo's offer comes with no origination fee. Since it is directly deducted from your loan proceeds, Lending Club's 3% fee bumps the APR (the actual cost of borrowing) up to 9.97%.
Is there a cheaper alternative that makes more sense?
Another important thing is to consider your options other than a personal loan. For example, if you have a credit card with a 0% APR introductory rate, it may make more financial sense to use it if you can pay off the balance before the promotional rate expires.
One popular alternative is a home equity loan or home equity line of credit (HELOC). If you have sufficient equity in your home, you can usually get a home equity loan with a more attractive interest rate and more flexible repayment terms than you could with a personal loan. Of course, the downside is that the loan is secured by your home, but if you have no reason to doubt your ability to repay, it could be an option to look into.
The bottom line
As I mentioned earlier, a personal loan can be a great option for people looking to consolidate high-interest debt or pay for a large expense. Rates, fees, and other terms can vary dramatically between lenders, so if you decide that a personal loan is right for you, it pays to shop around to find the best deal.