What a personal loan is and how it works
A personal loan is a type of installment loan that gives you a fixed amount of money in one lump sum. Personal loans are usually unsecured, meaning you don’t have to use collateral to secure funds. Repayment terms can range between one and twelve months. Personal loans can be used for almost anything, although specific lenders may impose restrictions on their use. Interest rates on personal loans are fixed, so your interest rate will not change while you repay your loan.
Applying for a personal loan is similar to applying for a credit card. You’ll need to enter your personal information, your financial information and the details about your desired loan. Before approving you, the lender will run a hard credit check, which may temporarily lower your credit score. If your financial picture and credit score are sufficient for the lender, he/she will set your loan amount and terms and inform you on the interest rate.
You’ll receive personal loan funds all at once and begin paying them back immediately. Your payment will be the same amount every month until your loan is paid off: a portion of your principal, plus interest charges depending on how much you have borrowed and when you are supposed to pay it back.
Pros of personal loans
Personal loans can offer benefits over other types of loans. Below are a few advantages of using this type of financing over other options.
- One lump sum
Because you get the loan payment all at once, it can be easier to make a large purchase, consolidate debt or otherwise use the loan all at once.
- Fast funding times
Personal loans generally have fast approval times and payment times, making them useful for emergencies or other situations where you need money quickly. Some personal loan lenders can deliver the money as soon as the next business day.
- No collateral requirement
Most Unsecured personal loans don’t require collateral for you to get approved. This means you don’t have to put your car, home or another asset up as a guarantee that you’ll repay the funds. If you’re unable to repay the loan based on the agreed-upon terms with your lender, you’ll face significant financial consequences. However, you don’t have to worry about losing a home or a car as a direct result.
- Flexibility and versatility
Some types of loans can only be used for a certain purpose. For example, if you take out a car loan, the only way to use the funds is to purchase a vehicle. Personal loans can be used for many purposes, from consolidating debt to paying off medical bills.
If you want to finance a major purchase but don’t want to be locked into how you use the money, a personal loan can be a good alternative. Check with your lender on the approved uses for the loan before applying.
- Loan terms
Unlike short-term loans like payday loans and others that charge very high interest rates, for personal loans you to have lower monthly payments and more reasonable interest rates.
- Easier to manage
One reason some people take out personal loans is to consolidate debt, such as multiple credit card accounts. A personal loan with a single, fixed-rate monthly payment is easier to manage than several credit cards with different interest rates, payment due dates and other variables.
Borrowers who qualify for a personal loan with a lower interest rate than their credit cards can streamline their monthly payments and save money in the process.
Cons of personal loans
Personal loans can be a good option for some, but they are not the right choice in all situations. Here are a few negatives to consider before taking out a personal loan.
- Interest rates can be higher than alternatives
Interest rates for personal loans are not always the lowest option. This is especially true for borrowers with poor credit, who might pay higher interest rates than with credit cards.
- More eligibility requirements
Personal loans can have more strict requirements than other times of funding options. If you have poor credit or a short financial history, fewer lenders will be available to you.
- Fees and penalties can be high
Personal loans may come with fees and penalties that can drive up the cost of borrowing. Some loans come with origination fees of 1 percent to 6 percent of the loan amount. The fees, which cover loan processing, can either be rolled into the loan or subtracted from the amount disbursed to the borrower.
Some lenders charge prepayment penalties if you pay the balance off before the end of your loan term. Before applying, review all fees and penalties of any personal loans you are considering.
- Monthly payments
With a personal loan, you are adding another monthly payment. If you are not careful, this can cause problems with your day-to-day living expenses or paying other essential bills.
- Increased debt
Personal loans can be a tool for consolidating debt such as credit card balances, but they do not address the cause of the debt. When you pay your credit cards off with a personal loan, it frees up your available credit limit. For over spenders, this offers an opportunity to rack up more charges rather than free themselves from debt.
- Higher payments than credit cards
Credit cards come with small minimum monthly payments and no deadline for paying your balance off in full. Personal loans require a higher fixed monthly payment and have to be paid off by the end of the loan term.
If you consolidate credit card debt into a personal loan, you’ll have to adjust to the higher payments and the loan payoff timeline or risk defaulting.
How to decide if a personal loan is right for you
Personal loans are an attractive option if you need quick cash. Here’s how to discern whether a personal loan might make sense for your situation:
- You need the funds quickly. With many lenders, especially those that operate online, funds can be made available in a matter of days.
- You have a strong credit score. The lowest interest rates are reserved for borrowers who have good credit.
- You want to pay off high-interest debt. Personal loans are a good way to consolidate and pay off costly credit card debt.
- You’ll use the funds toward necessary expenses. Other good reasons to use personal loans include paying for emergency expenses or remodeling your home.
However, personal loans are not a good idea for everyone. After all, personal loans are still a form of debt. Below are a few reasons a personal loan might not be right for you:
- You don’t have a viable purpose for the funds. It can be tempting to take out a loan to have extra funds on hand. But if you don’t have a plan for how the funds will be used, you risk spending money on and paying unnecessary interest on items that are not essential.
- You have a habit of overspending. Paying your credit cards off with a personal loan may not make sense if you’ll immediately begin building up a new credit card balance.
- You can’t afford the monthly payments. Consider a personal loan’s repayment timeline and monthly payments. Use a personal loan calculator to determine whether or not you can afford the monthly payments for the term you’ll spend paying it off.
- You don’t need the money urgently. It might make sense to build up your savings to pay for a large purchase instead of taking out a personal loan and making payments with interest for many years.
Alternatives to personal loans
There are instances where a personal loan may not be the most sensible option.
If you have sufficient equity in your home, you can borrow against it using a home equity loan or a home equity line of credit (HELOC). A home equity loan is an installment loan, while a HELOC works similarly to a credit card. One downside to having a home equity loan or a HELOC is that your home is used as collateral. If you default on the loan, you risk losing your home to foreclosure.
Credit card balance transfer offers are another alternative to personal loans. You can save money with a good balance transfer offer, provided you pay the balance off before the special offer period ends.
If your financial shortfalls are the result of overspending, a realistic spending plan is a more feasible option. Otherwise, you risk racking up an excessive amount of debt that could take some time to get rid of.
Before taking out a personal loan, make a plan for how you’ll use the funds and how you’ll repay them (with interest). Weigh the pros and cons of taking out a personal loan rather than using another financing option. Review alternatives such as a home equity loan, a HELOC or a credit card balance transfer. If you’re considering a personal loan, get quotes from several lenders to compare interest rates and loan terms. Don’t forget to read the fine print, including fees and penalties. Once you have all the data, decide if the benefits of a personal loan outweigh the drawbacks before making a commitment.