by Matt Frankel, CFP | July 3, 2019
Here are the terms you should know before taking out a personal loan.
When you’re applying for a personal loan, it may seem like the terms and conditions are written in another language. To help you out, here’s a primer. These 19 personal loan terms will bring your vocabulary up to speed and help you make the right decision.
How much you pay to borrow money over the course of a year.
For example, a $1,000 loan with a 15% APR would cost you $150 if you didn’t make any payments for a year. This includes the interest rate and any origination charges. The APR is a better representation of the cost to borrow than the interest rate.
The process by which a third party, like a lender, gets access to your bank account to withdraw a monthly payment.
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Autopay is also known as ACH (Automatic Clearing House).
A creditworthy individual who agrees to accept legal responsibility for repaying your loan.
If you don’t have sufficient credit, income, or other qualifications to get a personal loan on your own, some lenders will allow you to apply with a joint applicant or cosigner.
To be clear, most personal lenders don’t allow cosigners. If this is important to you, be sure to look for one that does.
A document that lists your debt obligations and payment records.
Negative credit information like charge-offs, collection accounts, and legal judgments can appear on your credit report as well.
There are three major credit bureaus that maintain credit reports for American consumers -- Equifax, Experian, and TransUnion. Each of these three can be used to generate a credit report and FICO® score.
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Your monthly debt obligations (mortgage/rent, car payment, loans, etc.) expressed as a percentage of your pre-tax income.
For example, if you have $1,000 in monthly obligations and earn $5,000 per month before taxes, you have a DTI ratio of 20%. Along with your credit and employment situation, your DTI ratio is one of the main factors lenders use to qualify borrowers.
The act of combining several debts into one.
For example, if you get a personal loan and use it to pay off four credit cards, you’ve used the loan to consolidate your credit card debt.
The failure to meet your repayment obligations on a loan.
If you default (stop making payments) on a personal loan, the lender can take legal action to collect the remaining balance. They might sell the debt to a collection agency or even sue you.
The most commonly-used credit scoring model.
Scores range from 300 to 850, with higher scores being better. When you apply for a personal loan, your FICO® Score is one of the main factors a lender uses to decide if you should be approved. It also determines your interest rate and other loan terms.
An interest rate that doesn’t change throughout the loan term.
For example, let’s say you get a five-year personal loan with an interest rate of 8%. You’ll pay an interest rate of 8% on your outstanding balance throughout the entire term of your loan. This contrasts with a variable interest rate, which we’ll discuss below.
An “official” credit check that shows up on your credit report and can affect your credit score.
A single inquiry isn’t likely to drop your score by more than a few points. Typically, a personal lender performs a soft check during the pre-approval process but will use a hard inquiry when you apply for the loan.
A debt that you agree to pay off in a certain number of installments.
For example, if you get a personal loan with a repayment period of 60 months, your obligation ends after you make the 60th monthly payment on the loan.
The amount of money a lender charges you for outstanding debt every year.
You can determine your monthly interest payment by multiplying your outstanding balance by the interest rate and dividing by 12. If you have $750 left on a loan with 10% interest, your monthly payment will be $6.25 ($750 x .10 = $75 / 12 = $6.25).
It’s worth noting that this payment wouldn’t reduce your principal balance. You’d have to pay more than $6.25 if you want to cover more than just interest.
A charge by a lender to compensate for the facilitation of your loan.
Origination fees can be expressed as a specific dollar amount or a percentage of the loan amount. Some personal lenders don’t charge origination fees. If you have less-than-ideal credit, you’re more likely to pay one.
A fee assessed if you pay your loan off early.
These are rare in the personal loan industry. But they do exist, so be aware of them.
Obtaining new debt to replace old debt.
People talk about consolidation and refinancing interchangeably, but they’re actually different. You can refinance several debts or just one. For example, if you have a credit card with an 18% APR and use a personal loan with a 10% APR to pay it off, you’ve refinanced the debt.
Debt that doesn’t have a set repayment date.
Credit cards are a form of revolving debt. There’s no set repayment date for a credit card -- it's an open-ended credit line that exists until you or the credit card issuer decide to discontinue it.
A credit check that doesn’t affect your credit score.
Think of it as a “sneak and peek” by a lender to see if you meet their qualifications. With personal loans, a soft credit check is generally used during the pre-approval process when borrowers check their interest rate offers.
A loan that isn’t backed by a specific asset (known as “collateral”).
Personal loans and most credit cards are unsecured forms of borrowing. In contrast, a mortgage is a secured loan because it’s backed by the value of your home.
An interest rate that adjusts periodically (usually annually) according to a benchmark index.
This is also known as an adjustable rate. You’ll often see personal loans that use the prime rate as a benchmark. For example, if your interest rate is prime + 4%, and the prime rate is 5% when your adjustment occurs, your loan’s interest rate will change to 9%.
By learning these terms before you start the personal loan application process, you’ll be better prepared to understand what you’re reading. And that helps you make smarter financial decisions.
Like any personal finance topic, the more educated you are going into the process, the better off you’ll be.
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