Personal Loans: What They Are, How They Work, and Their Benefits

Every year, millions of people take out loans from banks, credit unions and other lending institutions. Along with more conventional loans for buying a house or car, there are also “personal loans”.

Since lenders don’t require collateral to secure personal loans, you must have excellent credit. When you take out a loan to buy a house or car, the property or the vehicle gives the lender protection in the form of collateral in case you default on payments. That way, the lending institution can recoup some, if not all, of the money loaned to you.

One positive aspect of a personal loan is that you don’t have to justify to the lender the reason for wanting it. Instead, you can use the funds in whatever way you want, such as buying clothes for a new job, paying for college books and tuition, working on a home improvement project or buying a vehicle.

Unlike a credit card, which has different payment amounts depending on the balance, as well as fluctuating interest, personal loans have an installment structure. For that reason, the payment stays the same each month until you pay the loan in full. This type of loan typically has a fixed rate, meaning it never changes throughout the life of the loan, usually two to five years.

As you research personal loans, make sure you understand the full cost of the loan, not just what you would pay with interest tacked on. Sometimes, lenders charge additional fees and have varying conditions. So, read each word of the contract carefully before you seal the deal. If you don’t understand something, ask.

Qualifying Factors

When it comes to personal loans, you must have an excellent credit score. Lenders also will look at your debt-to-income ratio to ensure you can make the payments in full and on time.

The credit score needed for personal loans varies. Typically, lenders prefer borrowers to have a FICO score of 700 or higher. However, some lending institutions offer personal loans to people with a score as low as 600. It’s important to note that the higher your score, the lower the interest and the more you can borrow.

Currently, the average interest rate on personal loans for someone deemed creditworthy is as low as 5%. With a FICO score of 700 or higher, you should have no problem securing the money you need. However, because interest rates vary from one lender to another, it’s worthwhile to shop around before signing on the dotted line.

If you have a low credit score, you could end up paying as much as 36%. When the interest rate reaches that level, you might be better off borrowing money against a credit card. The only drawback is card issuers don’t usually offer the same amount of funding. For that reason, you would need to compare the pros and cons of each offer and then decide which one serves you best.

If your credit score is not high enough to qualify for a personal loan, you have two options. First, you can opt for a secured loan instead, which would require you to put up collateral. Second, you could have a family member or friend co-sign on the loan.

Before you agree to anything, you need to ask potential lenders direct questions, such as:

  • What’s the highest and lowest interest rate?

  • How much is the loan origination fee?

  • What’s the annual percentage rate (APR)?

  • What are the terms of the loan?

  • Does the loan have fixed-rate interest?

  • Is there a prepayment clause?

  • Are there any other fees associated with the loan?

  • How much is your penalty for late payments?

Potential Risks

As you can see, there are a lot of advantages of taking out a personal loan. On the flip side, there are a few drawbacks.

Default

If you took out a personal loan without a co-signer and don’t make the scheduled payments, the lending institution can sue you in a court of law for the money owed. As a result, you would have to not only pay the loan off in full but also pay hefty attorney fees and court costs. If you had a co-signer, the lender will go after that person to recoup the loaned money.

Prepayment

As you look over the contract for a personal loan, pay close attention to any “prepayment” clause. What that means is if you pay the loan off in full before the scheduled due date, the lender can penalize you via a hefty fine.

Fake Loans

Always select a reputable lending institution, preferably the bank where you do business. Unfortunately, scammers have come up with a host of ways to cheat innocent consumers. One involves luring people in with phony advertising that promises the moon but delivers nothing.

An advanced fee loan is another example. In this scam, the so-called lender requires you to pay an upfront fee in exchange for the loan. As you can imagine, the minute you pay the fee, the “lender” disappears.

Interest Rate

As mentioned, if you have less-than-perfect credit, and you only need to borrow a relatively small amount, it might be better to take money out against a credit card than to use a personal loan with a high interest rate. If you lack excellent credit, make sure you visit a lender that has a unique program for people in your situation.

When to Avoid Personal Loans

Although personal loans serve as a useful tool in many situations, there are times to avoid them. In addition, only secure a personal loan for the minimal amount you need and nothing more. After all, you want money to help with a specific issue, not put you at risk for financial disaster.

Unnecessary Purchases

You should never take out a personal loan for unnecessary things. As an example, you have several friends taking a cruise and they ask you to go along. However, you aren’t in a financial position to do that at this time. Instead of taking out a loan, you would be better off putting money aside each month in a high-interest savings account and then taking a cruise the following year.

Rebuilding Your Credit

If you have bad credit, you should do everything humanly possible to increase your score. However, you should avoid using personal loan money to pay down (or pay off) old debt. The reason is you’ll spend too much on interest.

One-Time Purchases

Even if you want a dream wedding, a vacation of a lifetime or the latest computer system on the market, avoid a personal loan. Using the money that you saved instead of taking out a loan will force you to spend what you can actually afford. For big, one-time purchases, plan ahead and put money from your income aside until you have enough.

The Bottom Line

There are multiple instances when a personal loan makes perfect sense. If you can secure a low interest rate and excellent terms from a respected lender, this kind of loan offers incredible benefits. Have more questions? Check out our loans guide!

Personal Loans - Finance Guru
LoansAndy Misek