What Is a Personal Loan?
Dana has been writing about personal finance for more than 20 years, specializing in loans, debt management, investments, and business.
Personal loans offer a way to borrow money for pretty much anything, from home improvement projects to unforeseen emergencies. A personal loan can fill the gap when your cash-on-hand will not cover the expense.
What is a personal loan?
A personal loan is money you borrow from a traditional bank, online lender, credit union, or other financial institution. You repay the loan by making fixed monthly payments, referred to as "installments" over a predetermined amount of time. Typically, personal loans are unsecured, meaning you don't have to provide collateral. Depending on your credit score, the interest rates charged for these types of loans vary from low to very high.
How do personal loans work?
When you take out a personal loan, you'll agree to make set monthly payments over a period of time in exchange for a lump sum of money. Once you know how much you need to borrow, you can shop around for the best deal.
Some lenders will use the information from a soft credit check to tell you if you qualify for a loan, how much you can borrow, what your interest rate will be, and how much they will charge in origination fees. If you agree to their terms, it's then that the lender conducts a hard credit check, which will knock a few points off your score.
Other lenders will not extend any form of offer until they've run a hard credit check. The good news is, credit agencies recognize the need to "rate shop." All inquiries for the same type of loan within a short time period count as one inquiry, no matter how many lenders you check.
While your credit score is an important factor in getting approved for a loan, it's not the only one. Lenders want to be sure you can afford to repay the loan so they also look at your income, employment history and debt-to-income ratio (DTI). DTI refers to the amount of money you owe compared to the amount you earn. For example, if you make $5,000 a month and your mortgage, car payment, and credit card costs total $2,500, your DTI would be 50%, which is high. The Federal Reserve considers a DTI of 40% or above to be a sign of financial distress.
Once you provide your information and assuming your loan is approved, the amount you owe will be a combination of your original loan amount, interest, and origination fees. A lender charges upfront origination fees to cover the cost of processing and distributing your loan. Origination fees range from 1% to 8% of the amount borrowed.
Unlike other loans, like those used to specifically purchase a home or vehicle, personal loans are available for just about anything. Borrowers frequently turn to personal loans to complete home improvement projects, pay for a special event, or consolidate high-interest debt at a lower interest rate.
What do I need to know about personal loans before I apply?
Like any financial decision, the smartest way to approach a personal loan is to research the best option for your situation. Here's what you should know:
- Personal loans are a great way to consolidate high-interest debt. Say you have balances on several credit cards, each carrying an interest rate of 16%. Combining those debts into one lower-interest personal loan will not only save you money, but it will also make bill payment more manageable and may prevent late payments.
- To compare one loan with another, you must factor in all the costs involved. While one may have a slightly lower interest rate, another may have low origination fees, making it an equal or better option.
- Some lenders charge a prepayment penalty for paying a loan off early. Shop for one that won't hit you with this extra charge.
- Personal loans come with different repayment periods, typically between 12 and 60 months. The longer the term you choose, the lower your monthly payment will be. That said, the longer you take to pay it off, the more it will cost you in the end. For example, a $15,000 loan at 6% interest over three years will cost $456 per month, and you will pay a total of $1,416 in interest. If you decide to extend the repayment term to five years, your payment will go down to $290 per month, but you will pay a total of $2,400 in interest. Most savings accounts could benefit from that extra $1,000.
- If your credit score is not up to snuff, you could save money if you work to raise your score before you apply. That's because a higher credit score may help you qualify for a better interest rate. Consider this scenario:
- Customer A and Customer B each apply for a personal loan of $15,000 with a three-year repayment term.
- Customer A: Has excellent credit and is offered a 6.99% interest rate. The monthly payments are $463, and it costs a total of $1,668 in interest.
- Customer B: Has a poor credit score and is offered an interest rate of 24.99%. The monthly payments are $596, and it costs a total of $6,456 in interest.
- That excellent credit score saves Customer A a total of $4,788 on the loan.
What are some alternatives to personal loans?
You've already asked yourself, "What is a personal loan?" Now it's time to ask, "What are my other options?" Here are two:
Promotional rate credit card
There are two types of credit cards that might work as an alternative to a personal loan. If you're looking to consolidate high-interest debt, you might use a balance transfer card. And if you want to finance an expensive purchase, you might use a 0% interest card. Before you apply, dig into a company's terms of service to learn about the total cost of making a balance transfer. In addition to a transfer fee of 3% to 5%, a credit card may charge you an annual fee.
Transferring debt from one card to another is as easy as letting the credit card provider know how much you want to be transferred and from which cards. Once you make a transfer, it's important to pay the balance off before the promotional period expires to avoid being hit with high-interest charges.
Personal line of credit
An unsecured personal line of credit acts more like a credit card than a personal loan. Let's say you're approved for a personal line of credit for $15,000 and borrow $7,500 to have central air installed. Once that $7,500 is paid back, the line of credit remains open, and you can borrow as little or as much (up to your $15,000 credit limit) again.
Access to your line of credit is available through online transfers and checks. While a personal line of credit offers flexibility, there are some drawbacks. Because it's not backed by collateral, banks charge a higher interest rate for an unsecured personal line of credit than something like a mortgage or car. The interest rate is linked to an index (such as the Prime Rate), meaning it can go up or down. And finally, you will likely be charged a maintenance fee to keep the line of credit open, whether you use it or not.
As the name implies, a secured personal line of credit is "secured" by putting something of value up as collateral, like a house or car. While it works just like an unsecured loan, the interest rate is typically lower because there is collateral involved.
Is a personal loan right for me?
A closer look at your specific financial situation will tell you whether a personal loan is right for you. If you can afford to wait and save up the money instead, that's always a better bet -- especially for non-essential purchases. But sometimes waiting is not an option.
If you use your personal loan to pay off high-interest debt, it may put you in a better financial position. You could get out of debt faster and streamline your billing-paying process. If your credit score is high and you can snag a low interest rate, a personal loan may also be the most cost-effective way to pay for projects around the house. The only way to know for sure is to crunch the numbers.