Personal loans can be used to fund a home improvement project, pay for a wedding or funeral, or — most commonly — consolidate credit card debt. The loan product became popular after the 2008 financial crisis and is now one of the fastest growing for banks.
But they’re not right for everyone, especially as banks and lenders raise their lending standards in 2020.
Most personal loans are unsecured, meaning they don’t require you to put up collateral, such as a house or bank account, as leverage for the bank. With personal loans, you take out a fixed amount of money and repay it over a fixed time period at a fixed interest rate. Though this seems simple, there are many intricacies to taking out a loan that aren’t immediately obvious, like checking what kind of fees are charged on top of a loan or making sure there are no errors in your credit reports.
Here are our most helpful dos and don’ts for getting a personal loan.
Personal Loan Dos
Do: Check your credit reports
Your credit score and credit history are major determinants in the interest rate you receive on a personal loan. Banks use credit as a barometer for risk. If you have made payments in a timely fashion before, then you are more likely to repay your loan. Therefore, the better your credit, the lower your rate. Generally, rates will range between 4 and 36%.
Due to the COVID-19 pandemic, the three major credit bureaus (Equifax, Experian, and TransUnion) are offering free weekly reports at AnnualCreditReport.com through April 2021. As due diligence, we recommend pulling your credit reports to make sure they’re in tip-top shape. An error (say, missed payments or a credit card fraudulently attached to your name) can wreak havoc on your credit score, so check for accuracy and dispute any information that isn’t correct.
Do: Compare the APR
The difference between a low interest rate and a higher interest can be major. Let’s say you have a $10,000 loan with a 5-year term. Over those five years, the difference in overall cost between a 10% APR and 25% APR would be $4,862.56. We always recommend shopping around before committing to a lender, as each one weighs your application information differently.
Do: Consider the risks if you have bad credit
If you have a credit score less than 670 (“good” by FICO standards), you may find it harder to get a decent interest rate on a personal loan. Additionally, those who have filed for bankruptcy or have not established a credit history will experience difficulties getting a loan.
People who find themselves in that boat may need to consider a cosigner to improve their odds of getting approved. A cosigner is a secondary borrower who can boost your loan application by offering their (presumably good) credit history. It provides reassurance to the bank that the loan won’t be defaulted upon, because there is a backup person who would be responsible.
Adding a cosigner can grease the wheels on an offer and even merit you a better rate than if you’d applied alone. But the risk is if you miss a payment, then you and your cosigner would experience a credit score decrease.
You may also need to consider a secured loan if your credit isn’t good enough. Most personal loans are unsecured, so putting up collateral (in the form of a house, car, or bank or investment account) gives the bank leverage in a situation where you may not be an attractive candidate. The interest rates on secured loans are often lower, though, of course, you take on significantly more risk if you cannot afford the payments at some point down the line. Defaulting on a secured loan could allow the bank to seize your collateral, meaning you could ultimately lose your house, car, or whatever else you put up for collateral.
Do: Look closely at the fees
Take a fine-toothed comb to your loan offer before accepting. You want to make sure you understand everything in the contract; otherwise, you may have to be forced to pay surprise fees in the future. These are the most important aspects of the personal loan to evaluate:
- APR: What is the interest rate? Is it fixed or variable? Is the rate lower than the one on your credit card? If not, then taking out a loan may not be worth it.
- Repayment period: How long will you be making monthly payments, and at what point will the loan need to be paid off?
- Monthly payments: Can you afford the payments? Do they fit into your budget?
- Secured or unsecured: Will you need to put up your bank account, for example, as collateral for the loan? Or does it not require collateral?
- Origination fee: Do you have to pay a fee up front for the loan, and if so, what does it cost? Is the lender being transparent? Keep in mind that many lenders that don’t require this fee still charge it anyway. It’s just reflected in your interest rate.
- Prepayment penalty: Will you be penalized with a charge if you want to pay off the loan early?
Do: Get pre-qualified by multiple lenders
Pre-qualification is a process where you self-report your financial information and desired loan terms to get an informal estimate of what personal loan you’d be qualified for. This step is different from getting a pre-approval or actually applying for the loan, because it doesn’t require the lender to review and verify your documents and it won’ result in a hard credit inquiry that would decrease your credit score by a few points. And pre-qualification doesn’t mean you’re actually approved; it just tells you whether you’re likely to be approved and what your loan terms might be.
Getting pre-qualified is a quick, often instantaneous process that allows you to see what loan amount, interest rate, and terms you would receive. You can get pre-qualified by an unlimited number of lenders. We recommend getting estimates from at least three lenders so you can understand what is available to you, based on your credit profile.
Personal Loan Don’ts
Don’t: Accept the first loan offered to you
Always shop around before committing to a loan. It’s not just the obvious banks that are offering personal loans now. You can also find them at credit unions, community banks, online banks, and online lenders, many of whom could offer you a better rate than your garden-variety mega-bank.
All lenders evaluate applications differently, with variables like income and credit weighted differently depending on the criteria. So you may find one bank doesn’t like that you were laid off from a job, while another doesn’t care because you have an “excellent” credit history. It all depends on factors outside your control, so make sure to expand your options.
Don’t: Take out the maximum loan possible
We don’t recommend taking out a big loan just because you can afford it. A loan payment that seemed manageable upon approval may be a mistake down the line, if you unexpectedly lost your job, for example. Farnoosh Torabi, finance journalist and host of the “So Money” podcast, recommends people not take out a loan payment that accounts for more than 5 to 10% of their monthly budget. Overborrowing can be just as dangerous as paying for something outright that you can’t afford.
Don’t: Skimp on payments
Schedule automatic withdrawals or monthly reminders to pay your personal loan. Payment history accounts for 35% of a FICO credit score, followed by credit utilization, length of credit history, credit mix, and new credit. Missing payments, or paying late, can hurt that credit score and make it difficult to get approved for loans, credit cards, or even apartment leases in the long term. Set yourself up for success now and put that recurring note on the calendar. You’ll thank the future you later.