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What is a personal loan?

Need some extra funds to make a big purchase, pay off debt, or cover the cost of a major expense like a dream vacation or wedding? Many people turn to personal loans in such situations.

A personal loan is money lent to you with interest. You have to pay the loan amount back plus interest within a timeframe you and the lender agree on.

One of the main reasons that people utilize personal loans is that, unlike a mortgage or car loan, they don’t need to be used for a specific purpose. They’re good for almost anything. And, unlike credit cards, they come with the added benefit of a fixed interest rate and repayment terms.

Here, we’ll discuss the basics of personal loans, including the different options available and the benefits that they offer.

How does a personal loan work?

Most personal loans are unsecured, meaning they do not require collateral. Collateral is a valuable asset the lender can take from you if you don’t pay back the loan, such as your home or car.

Lenders look at factors such as your credit report, credit score, and debt-to-income ratio to determine how risky it is to lend you money.

The interest you pay is called an annual percentage rate (APR). The APR is usually closely tied to your credit score. The better your credit, the better rates and terms available to you. Likewise, the lower your credit, the riskier you appear as a borrower, which translates to higher interest rates.

If you’re approved for a personal loan, you’ll receive a lump sum of cash, but you'll have to pay it back in monthly installments until the loan term expires.

Should I get a personal loan?

This is an important first question to ask yourself, so take some time to think about it.

Remember, you’ll owe interest for the duration of the loan, so you’re always paying more than the initial amount you’re borrowing. Take a hard look at your budget and determine whether you can cover the cost of monthly payments based on your financial situation. Also, factor in any other upcoming expenses you anticipate that may put a further strain on your budget.

If you’re taking out a personal loan for a large purchase or expense, determine whether it’s really worth it to have to borrow money to cover it. Are there other more cost-effective ways for you to fill that gap, or even hold off on making the purchase until you’ve saved enough to cover it?

If you can’t repay a personal loan, your credit will be impacted for a long time. Take your payments seriously. Make sure you need the loan and that you are able to pay it back.

On the flip side, if getting a personal loan to consolidate significant debt can help you pay off that debt faster, it might be a good choice. Doing so can potentially save you money by lowering your interest rate, as well as make it more manageable by lowering your total monthly payment amount.

Likewise, if you need a personal loan to cover something like essential home repairs, it can be a better route than credit cards. That’s because, especially if you have good credit, personal loans often have better interest rates than credit cards.

If you’re looking at a loan to cover medical expenses, check with the hospital first to see if their billing department will work with you on a payment plan.

At the end of the day, if you don’t need to take out a personal loan, then don’t.

Where do I start when getting a personal loan?

Once you’ve decided to get a personal loan, figure out how much to borrow. Don’t borrow more than you need to.

Next, check your credit score. Get an updated credit score from one of the three main credit reporting agencies—Equifax, Experian, and TransUnion. Once you have and understand your credit score, look into the various loan options from different lenders. There are two main types of lenders—banks or credit unions and non-banking financial institutions (NBFIs).

NBFIs can be finance companies, peer-to-peer lenders, and payday lenders. But, beware that this type of lender usually charges high interest rates to borrowers with poor credit who don’t have other lending options.

How can I find the best personal loan?

It's a good idea to shop around before applying for a personal loan. You might not know ahead of time which lender will give you the best offer. Lender A might have the lowest advertised APR, but Lender B could be the one that offers you the lowest rate.

Narrow down your options based on the following criteria.

  • Qualification requirements:

    Make sure you can get approved for a loan by reviewing the lenders’ basic requirements. There could be limitations based on your credit scores or history.

  • Maximum and minimum loan amounts:

    Make sure the lender offers loans for at least as much money as you need, and look to see if there’s a minimum loan amount as well. However, know that you might not get approved for as large of a loan as you want.

  • Interest rate type:

    Lenders may offer either a fixed-rate or variable-rate loan. Variable-rate loans tend to start with a lower interest rate, but the rate (and your payments) could rise in the future. If you want certainty, a fixed-rate loan may be best.

Look for online reviews and comparisons of lenders to learn about other borrowers’ experiences and see which lenders could be a good fit based on your creditworthiness.

What’s a good loan rate?

The average APRs for personal loans in the U.S range from 10 percent to 28 percent¹. The better your credit score the lower your APR will be.

Always compare your options. The loan with the lowest APR will be the cheapest to pay back, but check for hidden fees before signing up.

How can I apply for a personal loan?

It’s important to be strategic when applying for a personal loan. Generally, lenders will review your credit reports when you apply and a “hard inquiry” gets added to your credit history. Hard inquiries stay on your credit reports for two years and impact many credit scores for up to a year. Each hard inquiry can lower your credit scores a little, and multiple inquiries in a short period may increase the negative impact.

However, some lenders can conditionally pre-approve you for a loan with a soft inquiry which won’t impact your credit scores. You’ll still need to submit an official application and agree to a hard pull before receiving an official offer, but trying to get pre-approved can help you weed out lenders that might not be good fits.

Then, compare your estimated loan offers to your current debts. Create or update your budget with a plan for paying off the loan and build in some wiggle room in case other unanticipated expenses arise. Having a plan in place up front and focusing on your end goal of paying off the loan in full can help you commit to making your regular payments.

After getting pre-approvals and identifying potentially good lenders (including ones that don’t offer pre-approvals), submit official applications starting with the lender that you think is best. This can usually be done over the phone, or in-person, or online.

Depending on the credit scoring model the lender uses, multiple hard inquiries that occur within a 14-day (sometimes up to a 45-day) window might only count as one hard inquiry for credit scoring purposes. Additionally, the scoring model may ignore inquiries from the previous 30 days. So, try to submit all your applications within a two- week period to limit the impact on your credit scores.

If you get approved for a loan, read the fine print. Check the APR and any other fees and penalties. You should have a full understanding of the terms before agreeing to them.

Once you accept a loan offer, many lenders can transfer the money directly to your checking account. You can then use those funds to pay off your current debt and then focus on repaying your debt consolidation loan.

What are some other loan options?

Personal loans aren’t for everyone. If you need funds now, there are always other options that may suit your needs better. Each of them charge interest, but they’re worth considering.

Here are a few alternatives to personal loans, all of which carry their own risks and benefits depending on your situation. Take some time to research each to determine whether they may make more sense for you.

Personal loans can be complicated, and finding one with a good APR that suits you and your budget takes time. Before taking out a personal loan, make sure that you will have the ability to make the monthly payments on time. If you understand the terms and are confident you can pay it back, it might be a good option for covering the expenses you need it for. Not to mention, making on time payments and eventually paying off the loan can have the added benefit of boosting your credit score in the long run, as you’ve proven yourself to be a reliable borrower.

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