What Is a Personal Loan and How Does It Work?
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A personal loan is a loan that can be used for a variety of financial needs. They typically offer short to medium-length repayment periods and the funds from the loan are distributed to the borrower within a matter of hours or days.
Of course, taking on debt should always be considered carefully. Let’s look at how personal loans work, when to use them, and what you’ll need to qualify.
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How a Personal Loan Works
Personal loans are exactly what they sound like: They are loans provided to borrowers which can be used for a variety of personal purposes. These loans are provided to individuals (not businesses), can be obtained through a bank or peer-to-peer lending platform, and are flexible in nature.
In most cases, applicants do not need to put up any collateral to obtain a personal loan. These loans are sometimes called unsecured loans because they are not backed up by other funds or property. You may also hear them called debt consolidation or signature loans, depending on the borrower’s intended use.
Like other types of loans, a personal loan comes with an interest rate and repayment period — also known as the “term.” The applicant’s credit score and selected length of repayment usually determines the interest rate. Terms of repayment can last between a few months and several years. Minimum and maximum loan amounts might also apply.
Once the loan is issued, borrowers are required to pay back the principal amount of the loan, plus any interest accrued over the agreed-upon repayment period. Interest rates on these loans may be higher or lower than other types of debt, so it is important to compare options before determining which type of credit to pursue.
How to Use a Personal Loan
Personal loans are flexible by nature. That means you can use them for almost anything you need. Whether you are planning a big event or need extra cash to fix your roof, a personal loan may be a good option to help fund it.
A personal loan can also help you pay off debt faster. It can even help with cash flow problems when times are tight. Although I recommend building an emergency fund for most situations, you might not always have that option. In those instances, a loan may be what you need to help you get by.
What types of expenses could a personal loan cover? You might need one for:
- Consolidating high-interest credit card debt
- Consolidating other types of debt
- Home repairs and remodeling
- Medical expenses
- Major auto repairs
- Funeral expenses
- Wedding expenses
- Moving expenses
- Vacation expenses
- Attorney fees
- Business startup costs (when you can’t get a business loan)
- Furniture purchases
- Appliance purchases
Keep in mind that, while many personal loans are flexible, some are not. Be sure to comply with any stipulations on the use of the loan that your lender provides.
Should I Get a Personal Loan?
Applying for a personal loan is not something to take lightly. Debt can be a major drain on your finances and hold you back from reaching your financial goals. It limits the amount of money available for other expenditures and reduces the amount of freedom you have in regards to your spending, your career, and your life.
With that said, there are times when getting a personal loan makes sense. Having a fully-stocked emergency fund is often the best option for financial survival, but a loan may be appropriate for instances when it benefits you or when it provides badly needed funds. Consider a personal loan for:
- Consolidating High-Interest Credit Card Debt: Personal loans usually offer a markedly lower interest rate than credit cards. Using a these loans to consolidate credit card debt can help you pay it off faster and save you tons of money in interest.
- Unexpected Medical Expenses: Medical expenses can be a major budget-buster, especially when they are unexpected. These loans may be a good way to help you cover the cost.
- Emergency Home Repairs: It is best to save and pay out of pocket for routine home repairs and renovations, but using a personal loan to pay for an emergency repair could be necessary.
- Paying Back Family and Friends: Borrowing money from family and friends can put a major strain on your relationship. If you owe them money, it might be best to take out a loan and pay them back.
- Major Life Events: Events like funerals and weddings often cost thousands. While it is always best to plan ahead, using a loan to float some of the expenses may be necessary.
How to Compare Personal Loans
Personal loans are widely available from banks, credit unions, and peer-to-peer lending platforms. You can find many of the best personal loan rates online.
How do you choose between dozens of different loan companies? Compare these items to find the best personal loan option for you.
- Interest Rate: Interest rates are the most important factor to consider when applying for a loan, and rates may vary significantly between lenders. Be sure to shop around until you find the best rate for you. Companies like Credible can help you compare multiple loans at once.
- Term Length: The length of your loan is probably the second most important consideration. In addition to your interest rate, your term length will have a major impact on the size of your monthly payment. Obviously, it also determines how long you will be paying off the loan.
- Fees: Banks might charge a variety of fees on your loan, including origination fees, prepayment fees or penalties, late fees, and more. Some of our favorite companies, including SoFi, do not charge any of these fees. Be sure to compare fees, especially origination and prepayment fees, because these could add to the overall cost of your loan.
- Time to Disbursement: If time is a major consideration, compare how long it will take the bank to actually disburse the loan.
- Prequalification: You may be able to prequalify for a loan with many lenders. This means that they will pull a “soft credit check,” which should not affect your credit score. (A “hard credit check” typically has a negative impact on your credit score.)
- Other Benefits: As with all banking products, banks are constantly competing for your business. One lender might offer better rates if you set up automatic withdrawals, while another might provide assistance if you lose your job. Compare these benefits before making your final decision.
Qualifying for a Personal Loan
Your ability to qualify for a personal loan is based on a number of factors. In most cases, your credit score will be a major factor in determining your eligibility and interest rate.
Generally speaking, the higher your credit score, the better your chances of being approved for the loan. Higher credit scores also tend to be approved for lower interest rates, although other factors — including the loan’s term — will also affect your rate. Most lenders use your FICO® score, but getting a free credit score can provide a good idea of where you stand now.
Don’t worry if your credit score leaves something to be desired. Some banks offer bad-credit loans that you can use to help fund your expenses. These loans will likely carry a higher rate and stricter terms, but they are available, nonetheless.
In addition to credit scores, lenders often use other information to determine whether you qualify for a personal loan. Other factors could include your income, credit report, payment history, and additional outstanding loans. Each lender weighs these factors differently, so it is important to shop around before making a decision.
Personal loans provide a fast and easy way to access money for a variety of expenses. They are widely available and often provide better interest rates than other forms of debt.
Whenever possible, it is best to plan ahead for expenses and pay for them with money you have saved. However, when used properly, a personal loan can be an acceptable way to acquire badly needed cash or pay off other debts faster.
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