Guide to Personal Loans
Personal loans have grown in popularity, as consumers gain exposure to online and peer-to-peer lending sites that advertise interest rates lower than those available for credit card advances. Furthermore, repaying a personal loan responsibly can boost your credit score more than a credit card advance would, because the credit bureaus give higher marks to fixed-term loans than they do to revolving credit lines.
What Are Personal Loans?
A personal loan is an unsecured, fixed-rate loan used for personal, rather than business, reasons. By “unsecured,” we mean you don’t have to put down any collateral. Contrast this with a mortgage or auto loan, where the lender can repossess property if you fail to repay the loan.
Since personal loans are unsecured, they require a certain amount of underwriting, which means the lender must feel comfortable enough about your creditworthiness to give you the loan. Underwriting is also the basis for how much the lender will offer you and how much interest it’ll charge.
Access to a personal loan largely rests on your creditworthiness and your current debt-to-income ratio. To assess your creditworthiness – that’s, the likelihood that you’ll repay the loan on time – personal loan providers check your credit score and credit history with at least one of the major credit bureaus – Experian, TransUnion or Equifax. The most common credit score is FICO, with a range of 300 to 850. It’s problematical to get a personal loan with a score below 700, and almost impossible for scores lower than 600.
Access also varies by the type of personal loan provider. Lenders in the personal loan market include banks, credit unions and online lenders, which may be one of three types:
Direct: the online lender supplies the loan proceeds using internal funding and money from investors
Peer to peer: the website facilitates loans between individual borrowers and lenders
Matching: the website matches your loan request to one or more members of its affiliate lending network
The type of lender affects the cost and accessibility of a personal loan, which will enter your considerations when picking a lender. In general, banks and credit unions have the lowest-cost personal loans but are very picky about who they lend. Banks usually have the most stringent underwriting requirements and credit unions require membership to access loans, although they usually offer the best rates because they’re non-profits. Online lenders give access to almost all borrowers that meet minimum requirements, but they charge more than banks.
Minimum requirements vary, but usually include:
Being a U.S. citizen or resident alien of age 18 or older
Having a dependable and verifiable source of income
Providing documentation such as Social Security number, bank account information and more
Your debt-to-income ratio is the ratio of credit available to credit used. It’s reflected in your FICO score and is often considered separately as well. Lenders get nervous when you ask for a personal loan after you’ve exhausted your existing credit resources such as credit card limits.
If you have excellent credit, you can probably secure a personal loan for an annual percentage rate (APR) of about 6 to 8 percent. At the other end of the spectrum, if your credit score is in the low 600s, you might be looking at an APR exceeding 30 or even 40 percent. For any given FICO score, you might find rates that vary by as much as 5 percentage points among lenders.
When comparing costs, it’s important to distinguish between interest rate and APR. The interest rate is the amount of interest you will pay for your loan, on an annualized basis. APR is also an annual rate, but it includes fees, which can be low or high, depending on the lender.
The most common fee is called an origination fee. It’s assessed up front and, like points on a mortgage, it simply adds to the lender’s profit margin. A large origination fee will create an APR significantly higher than the stated interest rate. Other fees to be wary of are prepayment penalties (in case you want to pay off the personal loan early), late fees and uncollectable payment fees.
Another interest-related consideration is the method the lender uses to compute interest charges, as this could affect your total cost if you decide to prepay your loan. The best deal you will get is called simple interest, in which you pay each month the amount of interest that has accrued on your balance since your last payment.
You’ll want to avoid lenders who charge pre-computed interest. This is a procedure in which the entire interest cost for the term of the loan is added directly to your initial loan balance. If you pay off your loan at the end of the stated term, there isn’t cost difference between simple interest and pre-computed interest. However, if you plan to retire the debt early, the pre-computed interest method will cost you extra money, as explained here.
Many borrowers consider convenience to be an important factor when choosing a personal loan provider. Banks are notoriously slow when it comes to approving personal loans, and usually require the most paperwork. You can usually apply online, but if the bank is small, you might have to travel to a branch office to apply. Credit unions are perhaps a bit faster and less cumbersome, since you provided some information when you became a member.
Online lenders use streamlined applications, make quick decisions and deposit loan proceeds into your account within a business day or two. An online lender may also be more flexible if you want to change the monthly payment date or renew the loan before it is fully paid off.
A personal loan can be used for virtually any reason. Getting one may allow you to finance big-ticket purchases or consolidate debt. Before you sign up for a personal loan, comparison shop among different providers and consider alternatives such as secured loans, credit card advances and home equity loans.