How Do Personal Loans Work?

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Personal loans are surprisingly popular. More than 20 million consumers have one, with an average debt of $8,402 per borrower. 

It’s not hard to see why. In good times, the personal loan can be used to fund basically any expense, including home repairs, launching a business, or even wedding and funeral costs. In tough times, they’re used to tackle credit card debt by consumers who can get a lower interest rate on a loan than what their card issuers are charging.  

But the pandemic and resulting economic downturn led banks to tighten their lending standards for new loan applicants while focusing on relief measures for existing customers. 

So financial experts say you need to weigh your options more carefully than ever when considering a personal loan. While lower interest rates could make a personal loan more attractive, you’ll have to demonstrate a sterling credit history before locking in those advertised rates.

Pro Tip

Personal loans offer versatility when you need cash for an emergency or major planned expense, but keep in mind that your interest rate will depend on your creditworthiness.

Anuj Nayar, financial health officer of LendingClub, said LendingClub has paused customer acquisition marketing and focused efforts on existing customers, to whom they’re offering payment deferments in the case of financial hardship. As for new applicants, underwriting requirements have become more stringent. LendingClub is now asking for more verification and pulling back on the types of loans offered to people with average-level credit.

Other major banks and online lenders we reached out to would not comment on loan application volume since the COVID-19 pandemic started, though some are offering reprieve to existing customers. U.S. Bank, for example, is offering a temporary rate reduction (fixed 2.99% APR) for existing unsecured personal loans under $5,000 with terms up to 48 months, according to a spokesperson. 

As always, the choice to get a loan is highly dependent on your life goals, financial history, other debt levels, and personal risk tolerance. There are steps and precautions you should take before signing on the dotted line, lest you get trapped into monthly payments you can’t afford. 

We asked Nayar and Farnoosh Torabi, financial journalist and host of the ”So Money” podcast, for their insider tips on personal loans.

How Personal Loans Work

Personal loans are known for their versatility and flexibility. They can be used for consolidating credit card debt, launching small businesses, implementing home repairs, refinancing student loans, funding vacations, and a number of other expenses — both necessary and discretionary. 

The way it works: You borrow money at a fixed interest rate for a fixed period of time, and you pay it off with a fixed monthly payment. Most personal loans are unsecured, meaning they don’t require collateral, such as your house or car, for loan approval.

Potentially lower interest rates, combined with fixed payment terms, can make personal loans more attractive than credit cards. “If you’ve got multiple credit cards that are all over 20% interest, and you can get a personal loan at 10%, then a lot of times I see people using that loan to save money on interest,” Torabi explains.

The terms of personal loans can vary based on your creditworthiness. To get the best interest rate, you will need to have a good to excellent credit score and a strong credit history that shows lenders that you will not be a risky investment for them.

Pros of Personal Loans

Potentially low interest rate: Depending on your creditworthiness, the rate you receive on a personal loan may be half or a third of a credit card’s APR.

Flexible uses: While many of these uses may not be recommended, loans can technically be used to cover any number of expenses, including weddings, vacations, divorces, funerals, student loans, home improvement projects, medical bills, small business launches, and credit card debt.

Fixed terms: Generally, the terms of a personal loan will be simple and straightforward. Your interest rate, term length, and monthly payment amounts will be fixed and not subject to the whims of the market. 

Unsecured: Most personal loans do not require you to put up collateral, like your car or house, as a requirement for loan approval. 

Big lending market: You don’t necessarily have to go to a traditional brick-and-mortar to secure a loan. Community banks, online banks, credit unions, and lending startups are also options — and rates may even be better because of lower overhead costs.

Cons of Personal Loans

Hidden fees: When shopping and negotiating for a personal loan, it’s important to inquire about origination fees (one-time fees between 1% to 8% of the loan amount) and prepayment penalties (fees incurred for paying off a loan early). Otherwise, the loan that looks good on paper may end up costing you more in the long run.

Requires good credit: If you have poor credit history, or no credit history, then it may be difficult for you to procure a personal loan, much less one with an agreeable interest rate. The better credit history you have, the better APR you’ll get.

How Your Credit Score Impacts Your Loan

Your credit score is one of the biggest factors lenders use to determine whether you qualify for a personal loan and your interest rate. It can help them determine your financial responsibility and likelihood of making payments on time.

Generally, the better your credit score, the more likely you are to qualify for a loan, and the lower your interest rate will be. If you have a fair or poor credit score, you can still potentially qualify for a loan, but you might be limited to certain loan types or assigned a high interest rate. 

Types of Personal Loans

Secured vs. unsecured loan

Most personal loans are unsecured, meaning there is no collateral and lenders take on potential risk by lending you money. A secured loan requires some form of collateral (such as your house, car, or bank account) that lenders can claim if you fail to pay back your loan. If you can’t qualify for an unsecured loan, a secured loan can help you gain access, even with less-than-great credit. By putting up collateral, you may also be able to secure a lower interest rate. 

Fixed vs. variable rate loan

A fixed-rate loan has an interest rate that remains constant throughout your loan term. Most loans have a fixed rate, and if you prefer predictability, this is the best option. Variable rate loans may offer lower interest rates, but the rates fluctuate with the market over the lifetime of your loan, making them less predictable for you as the borrower. They can still be an option to consider if the lower starting rate is attractive to you and you can afford to take the risk. 

Co-signer loan

Some loans require you to jointly apply with somebody else. Attaching a co-signer when applying for a personal loan — especially if you have bad or little credit — can increase your attractiveness as a borrower if the co-signer has a solid credit history and level of financial responsibility. This can help you qualify for better loan terms, but you should feel confident in your ability to pay back the loan before you apply; your financial responsibility will now not only affect your own credit score but that of your co-signer as well. 

Debt consolidation loan

One of the primary reasons for applying for a personal loan can be to consolidate debt, and some personal loans are specifically designated for that purpose. The goal here is to consolidate your debt into a single loan that has a lower interest rate than your current debt, allowing you to save on interest. This streamlines the number of payments you make each month and may help you pay off your debt faster. Debt consolidation loans typically have the same terms and APR as other personal loans, but may offer options to make the process more efficient, such as allowing you to pay your lenders directly through the loan provider. 

Credit builder loan

Credit building loans can be an alternative to credit cards if you’re looking to improve your credit score. Once you have been approved for a specific loan amount and term, you’ll begin paying monthly until you’ve met the total, at which point you will have access to the full loan amount. If you have poor credit or no credit, then this is an option to consider; as you pay, your lender will be reporting to credit bureaus. As long as you make your payments in full and on time each month, you will build credit. 

Where You Can Get a Personal Loan

There are plenty of options for lenders to consider when getting a personal loan, and certain types of lenders may be better suited to your goals than others.  When you’re considering where to get a personal loan, understanding the pros and cons of these options is essential. 

Banks

Brick-and-mortar banks: Traditional banks (such as Chase or Bank of America) may have strict lending guidelines, including higher interest rates and minimum credit requirements. They do offer the opportunity for in-person customer service, and if you’re an existing customer, you might be met with more flexibility. 

Community banks: Small, local banks also offer the benefit of in-person representatives to help you out, and may come with shorter wait times than larger chains. They might be able to offer rates that compete with larger branches due to their size and cost-efficiency. 

Online banks: Banks without brick-and-mortar branches often have fewer expenses than traditional banks, because they don’t have the same overhead costs. This allows them to offer lower rates, along with the convenience and speed of banking access immediately and remotely. 

Credit unions

If access to in-person service is something you value, credit unions can be a great choice. Because they are non-profits, they work more closely with individual circumstances. But there are generally limitations around who can qualify for their services, so ensure your eligibility before you apply. 

Online lenders

In addition to online banks, numerous start-ups have emerged to provide lending services online, making the process easier and more efficient. These lenders may offer potentially lower rates, options for prequalification, speedy transactions, and leniency around poor credit. If you don’t have a personal necessity for in-person service, you can likely find an online lender best suited for your financial situation.

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