What is a Personal Loan and How Does it Work?

Personal loan

Personal loans are a form of installment credit. That means you borrow a fixed amount of money and pay it back with interest in regular, monthly installments over the lifetime of the loan, known as its term.

A personal loan is a great way to get your hands on some extra money in case of an emergency such as a debt, car repair, or other unexpected financial situation. One of the most convenient ways to obtain a personal loan is to apply with your bank or local credit union. It’s important to remember that any funds that you borrow often come with origination fees, interest charges, in addition to the principal amount that you receive. 

How Do Personal Loans Typically Work?

Personal loans are a form of non-collateralized debt that attaches to factors such as your monthly income, credit score, and ability to repay. Often there are stipulations that apply to your loans such as required repayment schedules, credit defaults, and hefty interest rates. 

The loan interest rate is determined based on a number of personal factors, the most important being your credit score. 

If you don’t have a lengthy credit history or have experienced some blemishes in the past then you can also consider applying for a secured loan. These loans may not have as stringent requirements as a traditional personal loan since you will be required to provide something tangible such as a vehicle title of equal or higher value to ensure payment in case of default.

Different Types of Personal Loans 

When considering whether or not to take out a personal loan, you may want to keep in mind that there are several types to choose from. Your individual circumstances will help you determine which type you are likely to qualify for. For instance, a person with a healthy financial history may opt for an unsecured loan while someone coming out of bankruptcy is deemed a higher financial risk and may be required to produce a co-signer or provide additional collateral.

Below are the main types of personal loans that are offered at most lending institutions:

  • Secured Loan A secured loan is backed by a form of collateral owned by the person who is seeking to obtain funding. These borrowers are seen as riskier due to past issues.
  • Unsecured Loan – An unsecured loan is based on your credit history and income. This type of loan is the easiest to secure.
  • Line of Credit A line of credit (LOC) is an account that lets you borrow money as needed, up to a preset borrowing limit and repaid either immediately or over time. A line of credit is provided by a lending institution such as your current bank or credit card issuer.
  • Debt Consolidation Loan Debt consolidation loans are offered to those seeking to repay a variety of debts without juggling multiple payments. 
  • Buy Now Pay Later (BNPL) – These loans are geared towards those who are seeking a short-term solution to finance purchases online or in retail stores. They offer a convenient way to afford items however, they come with higher interest fees and can severely impact credit if not resolved in a timely manner. 
  • Joint Loan – A joint loan is also considered a co-signer loan since it requires you to have an additional guarantor with a stellar credit background. However, in the case of a default, the balance can be pursued against both parties.

Interest Rates and Other Fees

Many financial products contain a variety of fees and other charges that can seem hidden if you aren’t carefully paying attention. Some important factors to consider when searching for a personal loan are the following:

  • Origination Fees – A surcharge which can be a percentage of the total loan amount you are borrowing
  • Late Fees – A penalty fee assessed as a result of untimely payments, usually one-time but can also be recurring.
  • Interest Rates – Interest rates are a percentage rate that is charged by the bank for the money that you borrowed. For example if you borrow $5,000 for a term of 365 days with an annual interest(percentage) rate of 7.5% then you would have to repay $5,253.82 at the loan completion date.

Pros and Cons of Personal Loans

A loan can be used as a quick method to get out of a dire situation and often come with perks such as easy access to cash, flexible repayment terms, and minor paperwork for approval.  It is also important to be aware of the fact that the inability to repay a loan could have far reaching consequences for your finances.

Pros

  • Fast cash
  • Instant approval
  • Periodic repayment terms
  • Rollover ability

Cons

  • Exorbitant fees
  • High default rates
  • Increased interest rates
  • Loss of collateral

Impact on Your Credit Scores

A successfully paid personal loan can drastically increase your credit score as your credit report shows lenders that you can handle making payments responsibly. Although, a history of late or incomplete payments can damage your credit rating.

Another factor that can impact your credit score is the process of applying for a personal loan. The credit check required to assess your background for approval is known as a hard inquiry and can reduce your score by a few points. 

How to Compare Personal Loans

When it comes to personal loans one size doesn’t fit all and some additional research may be required to ensure that you are receiving terms that you can afford. A detailed comparison of factors such as term length, interest rate, origination fees, and credit requirements may save you from shelling out additional funds when it comes to your monthly budget.

When comparing loans you may also see an annual percentage rate, or APR, in your loan offer. Unlike the interest rate which only represents the percentage of the loan you’re charged for borrowing, APR represents the annualized cost of repaying the loan and includes the interest rate and any fees. 

When is a Personal Loan a Good Idea?

A personal loan is a good idea whether you are in need of a long term line of credit, a quick bailout, or any other situation where other types of financing isn’t available at the moment. The most common reasons for obtaining a personal loan are student loan debt, car repairs, job loss, or a significant purchase. 

How to Apply for a Personal Loan

Getting approved can be as simple as submitting an online application or applying with your local financial institution. Documents including proof of income, credit reports, proof of residence, and identity verification are sufficient in most situations. However, at times there will be additional information required dependent upon the guidelines of the lender.

Conclusion

Getting a personal loan doesn’t have to be complicated. A myriad of options are available for those with a positive credit background and a plan to pay off the debt. Once you find the right lender, a loan is just one step in easing your financial burden.

Previous articleWhat is a Money Market Account
Next articleWhat is an Adjustable-Rate Mortgage (ARM)?