A Beginner's Guide to Personal Loans
Most financial experts will advise you to avoid debt whenever possible. Still, there are times when borrowing — especially within the context of a well-conceived and -followed plan — can be a useful or necessary tool. Before you jump into filling out applications, however, there are some critical points to understand first.
What is a Personal Loan?
Personal loans are made for a fixed amount of money, typically lent to you by a credit union or bank, with a fixed interest rate and set repayment terms. Unlike other types of loans (such as auto loans), personal loans often don't have physical assets attached to them. Due to this lack of collateral, interest rates for personal loans tend to be slightly higher than other types of loans.
For example, an auto loan utilizes the car or truck as collateral. If you don't make your loan payments, your car can be repossessed and re-sold to allow the lender to recoup (at least some of) their losses. Higher interest rates on uncollateralized loans offset this additional risk.
Many times, personal loan funds represent a lump sum of cash that you can do with what you like.
How Can You Use a Personal Loan?
Some lenders will put stipulations on how a personal loan is used, particularly for borrowers with troubled credit. In these cases, the funds might be loaned in the form of a check written to another debtor, for instance.
But many times, especially if you’re not a high credit risk, the personal loan funds are distributed directly to you without such stipulations. In these cases, the loan represents a lump sum of cash that you can do with what you like.
A few common uses for personal loans include:
- Home Improvement
Moderate repairs and upgrades to your home can often require a fairly substantial amount of upfront resources; for this reason, many people utilize personal loans to make these improvements.
The problem with unexpected emergencies is that they're, well, unexpected. Everyone should have an emergency fund to cover at least six months of expenses, but it's often the case that people haven't saved enough to cover an unfortunate emergency, such as property damage from a storm or accident, the sudden illness of a family member, or unforeseen pet medical care.
Medical bills can be costly; while you may have insurance, most insurance plans only cover some medical expenses. Out-of-pocket expenses like co-pays, deductibles, at-home nursing care, or extended time away from work might need to be covered upfront. Hopefully, you never find yourself in this situation. However, if you ever do, personal loans can be a great resource to cover these expenses.
As anyone with an excellent credit score will tell you, paying off debt is a crucial element of healthy credit and managing financial stress. Higher-interest debt can compound and cost more over time; in these situations, taking out a personal loan at a lower interest rate can be a smart financial decision.
Understanding Personal Loan Terms
When applying for a personal loan, you’ll no doubt come across a few key terms.
- Interest Rate
The interest rate is the amount of money you'll pay back in addition to the amount borrowed, expressed as a percentage. For example, if you take out a $5,000 personal loan at an interest rate of 10%, you will have to pay back $5,500 ($5,000 + $500 or 10%).
Concurrent with interest rates, some personal loans include additional fees. The annual percentage rate (APR) is the yearly amount you'll pay, including the interest rate and any fees.
- Repayment Terms
The repayment terms dictate how often and long you will have to pay back your loan, plus interest and fees, in addition to the minimum amount you'll be paying — usually monthly.
- Prepayment Penalties
If your loan has a prepayment penalty, paying your loan back before the end of your repayment terms results in an extra fee, essentially to cover the loss of interest earned by the lender. Not every lender or personal loan includes prepayment penalties, so be sure to know all of the terms before applying.
Some lenders might include additional fees, such as origination and service fees. Sometimes these amounts are nominal; however, these additional costs can also add up quickly, so be sure to look over all the fees attached to your loan before you sign.
How to Apply for a Personal Loan
Applying for a personal loan is a straightforward process. Once you've read over all the terms from the lender, fill out and submit your application, and wait to receive a decision. The lender will review your loan application and consider any number of factors, typically including your credit history, debt-to-income ratio, employment, and income. The better positioned these factors are, the more likely you will qualify for a lower interest loan.
Is a Personal Loan Right for You?
When applying for a loan, the most important rule is that you should only take out a personal loan if you need it and can afford to pay it back. And the faster you can do so, the less interest you'll be paying. Personal loans are meant for well-thought-out strategic financial decisions. A personal loan should not be seen as free money, as all loans come with a cost.