When you need cash for something other than a car or a home, a personal loan seems like an inexpensive way to get the money you need. Money from a personal loan can be used for just about anything, and people with great credit scores can find excellent interest rates. However, such a loan may not be the best type for your personal financial situation. In this guide, we explain the ins and outs of personal loans and how they work so you can decide if one is the right option for you.
What Are Personal Loans?
A personal loan allows borrowers to take out a fixed amount of money to use for just about anything. People commonly use them to cover the cost of weddings, medical bills, and home improvements and to pay back higher-interest debts.
In general, personal loans are installment loans, which means that borrowers will pay back a fixed amount every month until the loan is paid off.
How Do Personal Loans Work?
When you take out a personal loan, the bank will transfer money to your checking account. Once the cash clears, you can use the money to make a purchase or to pay off existing debt. Your bank may stipulate that you must use the money from the loan for the purposes listed in your credit application. If you’re using a personal loan to refinance credit card debt, your lender may directly pay off your existing credit card debt in rare circumstances — mainly when you have poor credit.
You can expect to pay an “origination fee” when you take out a personal loan. Origination fees are commonly 1 to 6 percent of the overall loan value. Most of the time, you will finance the origination fee. For example, if you want to borrow $10,000 and the lender charges a 2 percent origination fee, you’ll actually take out a loan for $10,200. Alternatively, you might borrow $10,000 and receive only $9,803.92 (the rest of the loan goes to pay the origination fee).
Usually, personal loans are “unsecured” by an asset. This means that if you default on one of these loans, a bank will have to gain a judgment against you to collect the money it’s owed. Because personal loans are riskier propositions for banks, they have higher interest rates than secured loans such as mortgages or auto loans. However, rates on personal loans are generally lower than those for credit cards.
Also, carrying debt on a personal loan (compared with doing so on a credit card) may boost your credit score. A personal loan will immediately reduce your credit card utilization ratio. Additionally, over time you’ll build a history of on-time payments to an installment loan, which increases your credit score in a hurry.
What Can a Personal Loan Be Used For?
A personal loan is a general purpose loan. That means you can use it to pay for just about anything unless otherwise specified. Of course, taking out a personal loan isn’t always the savviest financial move. Below are a few of the best and worst reasons to take out a personal loan.
Best Uses for Personal Loans
- Debt consolidation — A personal loan is a great tool to help you to reduce the interest you’re paying on existing debt. As long as you remain committed to avoiding new credit card debt, a personal loan can help you achieve debt freedom.
- Adoption — Adopting a child can cost tens of thousands of dollars. Whenever possible, you’ll want to avoid taking on debt during an adoption, but a personal loan could help you bring your child home sooner.
- Medical expenses — Before taking out a personal loan to pay for medical expenses, ask your provider about a zero percent interest rate payment plan. If you can’t afford the required payments, a personal loan could help you cover the expense.
- Starting a business — Financing a new business is risky, but if you can afford the payments on a personal loan, it could give you the funds you need to transform your dream into a reality. Just be sure that you’re starting a business and not funding an expensive hobby.
- Emergencies — If you can’t find a zero percent annual percentage rate (APR) credit card, a personal loan can help you finance everything from a vet visit for your favorite furry friend to moving expenses associated with a sudden job change. An emergency fund is the best option, but a personal loan can work in a pinch.
- Home repair — In general, a home remodel should be paid for out of cash flow or using a low interest HELOC (home equity line of credit), but homeowners shouldn’t delay necessary repairs for long. If you need to put on a new roof, take care of flood damage, or purchase a new heat pump, consider a personal loan if the other options are not available to you.
Worst Uses for Personal Loans
- Vehicle purchase — Buying a boat, RV, or motorcycle with a personal loan is a poor financial decision. When it comes to luxury spending, using saved cash is best. Even purchasing a car with a personal loan is generally a bad idea. Banks will often finance car loans as small as $7,500, so you can acquire a used car without considering a personal loan.
- Overspending — Spending money on a lavish wedding, a trip around the world, or brand-new furniture isn’t, in itself, a bad thing, but you shouldn’t use a personal loan for it. If what you’re buying is not something you need, it generally makes sense to pay for it in cash.
- Down payment for a home — In general, banks won’t allow you to finance a home down payment using a personal loan, but even if it is allowed, it’s probably not a great idea. Between your mortgage and your personal loan, a massive percentage of your paycheck will go to housing. If you can’t afford to save the 3.5 to 5 percent down payment required to buy a home, it probably makes sense to keep renting for the time being.
- Paying everyday bills — If you’re behind on bills and struggling to make ends meet, a personal loan might seem like a good way to catch up. Unfortunately, adding more debt can exacerbate the problem. Rather than turning to debt to solve your financial problems, consider whether you can increase your income by donating plasma, selling items on eBay, or working as a secret shopper.
Types of Personal Loans
Most personal loans are installment loans, which means that you make fixed-amount payments each month for a predetermined period of time. Once you’ve made all the monthly payments, you’ll have repaid the principal balance along with fees and interest charges.
During a typical payoff period, the interest rate on personal loans remains fixed (that is, it doesn’t change over time). This offers an advantage over credit card interest rates, which may fluctuate over time. Most personal loans have simple interest rate structures — you pay more interest in your early payments and less interest over time.
The alternative to simple interest is precomputed interest. When you take out a precomputed interest loan, the lender gets all the interest, even if you pay off the loan early. Such loans are generally a horrible deal, so we recommend staying away from them.
The following are a few of the most important terms you should understand when taking out a personal loan:
Fixed vs. Variable Rate Personal Loans
In general, personal loans are fixed-rate loans. This means that the interest rate on the loan will not change during your payback period. If you find a variable-rate personal loan, you should take the time to see when the interest rate adjusts and whether there is a maximum interest rate. Variable-rate loans are riskier than fixed-rate loans because an upward adjustment of your interest rate will mean larger monthly payments.
Secured vs. Unsecured Personal Loans
Most personal loans are considered unsecured loans. The lending criteria for secured loans are entirely based on your ability to repay the loan, taking into account your income, credit score, and existing debt load.
However, some people use personal loans to purchase assets like a used car, a boat ,or an RV. In those cases, the lender sometimes says that the asset you purchase works as collateral for the loan. If that is the case, the lender could repossess your car or boat if you fail to pay the loan.
Before applying for a personal loan, make sure you understand whether it is secured or unsecured. In theory, secured personal loans should have lower interest rates than unsecured personal loans. But in practice, secured personal loans tend to have higher interest rates because they are marketed to people with poor credit.
Personal Lines of Credit vs. Personal Loans
With a standard personal loan, you receive the proceeds when it’s first approved and then pay it off over time. This is called a fixed loan amount. The alternative to a fixed loan is a revolving loan that is an unsecured personal line of credit. Unsecured personal lines of credit are loans from which you can draw cash whenever you need to pay back the money. When you draw from a line of credit, you must make monthly payments on the loan until it is paid back.
Most personal lines of credit have variable interest rates, and you have to pay an annual fee even if you don’t use the credit. Many banks require you to have a checking account at their bank before they will consider you for a personal line of credit.
Short- vs. Long-Term Personal Loans
Most borrowers can expect to pay off a personal loan over the course of two to seven years. These long-term personal loans have moderate interest rates (currently from 6 to 36 percent at most online lenders) and reasonable fees.
The alternative to long-term personal loans are their short-term counterparts, which are more accurately called payday loans. Payday loans have high interest rates and high fees that drive the APR as high as 400 percent. Generally, payday loans won’t improve your credit and can exacerbate existing financial problems. They can be a major debt trap, because you may have to pay a fee to rollover the loan for an extra month.
If you need cash fast, a long-term personal loan or a cash advance from a credit card can be a better choice than a payday loan.
The Best Alternatives to Personal Loans
When it comes to funding an emergency or making a major purchase, a personal loan isn’t always the right solution. Before applying for a personal loan, consider some of these options that may offer you a better deal.
Balance Transfer Credit Cards
If you’re interested in consolidating credit card debt, and you have a good credit score you may qualify for a zero percent balance transfer credit card.
When you open a balance transfer credit card, you have a limited period of time to transfer existing credit card balances onto your new credit card. For a limited period of time — often six to18 months — the new credit card company will charge a zero percent interest rate for a limited period of time. When the introductory time frame expires, the interest rate returns to a higher interest rate.
Most of the time, balance transfer credit cards charge a 3 to 5 percent balance transfer fee, but this is still a good deal when you consider the low interest rate.
The only drawback to a balance transfer credit card is that many people use the balance transfer as an opportunity to overspend rather than to save on interest. If you haven’t fixed an overspending problem, a balance transfer credit card could be a curse disguised as an interest free loan.
Zero Percent APR Credit Cards
People who want to buy something big and finance it over time should look to zero percent APR credit cards before considering a personal loan. These cards offers a low interest rate (zero percent) for all new purchases for a limited period of time, often six to 18 months.
A zero percent APR credit card can be an easy and inexpensive way to finance car repairs, new appliances, or even medical bills. As long as you make sure to repay it before the promotional period expires, this type of card makes more sense than a personal loan.
People who’d like to finance something large, like a home renovation or an RV purchase, may want to consider a home equity line of credit (HELOC) before applying for a personal loan. HELOCs generally have variable interest rates, and although banks charge an annual fee to keep a HELOC open, the total cost can still be lower than that of a personal loan. If you have a lot of equity in your house, be sure to look into HELOC rates before you take out a personal loan.
A less common alternative to personal loans are cash-back vehicle refinances. If you have equity in your car, you may be able to refinance the car and get cash back from refinancing your current loan. Rates on vehicle refinances are comparable to new car loans, so a vehicle refinance loan could be a far better deal than a personal loan. Of course, the total cash you can get from such a refinance will be limited by the equity you have in your car. It’s also important to remember that car loans are secured by your vehicle, so if you fail to pay your note, it can be repossessed.
The Worst Alternatives to Personal Loans
If some of the better alternatives to personal loans don’t work for you, you’ll definitely want to try for a personal loan before resorting to one of these loan options:
Credit Card Cash Advance
Some credit cards allow you to take out a cash advance. These are expensive “loans” that charge you a fee for borrowing the cash and a higher interest rate that starts accruing immediately. Credit card cash advances are rarely a good deal.
High-Interest Credit Cards
The interest rate on a personal loan is likely to be better than that on a standard credit card. If you need to finance something big and can’t pay off a credit card right away, a personal loan is usually a better choice than a high-interest credit card.
Payday loans are short-term (usually 14 days to one month) loans that come with high interest rates and even higher fees. Payday loans also don’t require installment payments, so some people get caught rolling over the loans for several pay periods if they’re not making much money. Even a high-interest personal loan tends to be a better option than a payday loan.
Title loans allow borrowers to take out a short-term loan at a reasonable interest rate in exchange for a vehicle that acts as loan security. One in five title loan borrowers gets his or her car repossessed, and four in five borrowers need to take out a new loan to pay back the old loan, according to the Consumer Financial Protection Bureau Title loans are much riskier than personal loans and should be avoided if at all possible.
How to Find Personal Loans That Are Best for You
If you’ve decided that a personal loan makes sense for you, be sure to shop around for the best deal. Lowering your interest rate by just 1 percent can save you hundreds of dollars during the life of a loan, so it’s definitely worth the time to compare offers from multiple lenders.
These are the steps you should take to get the best rate on your loan.
Before You Apply
- Check your credit score. Before you apply for a personal loan, take a few minutes to check your credit score by by going to sites like AnnualCreditReport.com where you are entitled to your full credit report for free once yearly. In general, you need a credit score of at least 600 to qualify for a personal loan.
- Lower your debt-to-income ratio. It’s not always possible to lower your debt-to-income ratio before applying for a new loan, but it can help increase your odds of approval.
- Gather proof-of-income documents. Personal loans are approved based on your ability to repay the loans. That means you need a steady source of income. Freelancers and other people with variable incomes should gather income documents, such as the prior year’s tax return or a PayPal statement, to prove their income.
Shopping for Personal Loans
Apply at multiple lenders. Once you’re ready to apply for a personal loan, do so at multiple lenders so that you can compare offers. While this will mean that you have more than a few hard-credit inquiries on your credit report, it should not drive your credit score down too much. Most credit-scoring algorithms group all the credit inquiries within a week or two into a single “inquiry” for the purpose of scoring. Go to CentSai‘s “Best Personal Loans” guide to find some of the optimal lenders.
Compare Real Offers
After applying, a lender will give you loan paperwork if you are approved. Before you sign a loan, compare offers from multiple companies. In particular, you’ll want to choose the company with the lowest APR.
Personal Loan Fees and Penalties to Look Out For
Once you have offers in hand, be sure that you understand these terms before you sign the document.
- Origination fee — Most lenders charge an origination fee of 1 to 6 percent on personal loans. The loan will spell out the dollar value of your fee.
- Principal — This is the total amount that you’re borrowing.
- Interest rate — This is what the lender charges you to borrow the money. It’s expressed as an annual amount you owe relative to the amount of the loan that is outstanding.
- Late fees — Does the lender charge a late fee if you make a late payment? If so, how much is the fee?
- Penalty interest — If you make a late payment, does your interest rate rise? What is the new interest rate.
- Prepayment penalty — Most personal loans don’t charge a prepayment penalty, but you should verify that your lender won’t penalize you for pursuing debt freedom.
Can You Get a Personal Loan With Bad Credit?
The best way to get a personal loan is to have a great credit score and a low debt-to-income ratio. With these two ingredients, you’re likely to find a personal loan at a great rate. If you have a bad credit score, getting a personal loan can be a major problem. Most lenders want to see credit scores above 600 before they’re willing to extend a loan to you.
If you’ve got bad credit (a credit score below 600), some lenders may offer you a loan if you have a cosigner or if you have sufficient income to meet repayment criteria. Even with these advantages, you can expect personal loan interest rates to soar into the high double digits.
Borrowers with bad credit also need to watch out for scams such as advance fee loans. These scams are run by fraudsters who collect fees before you take out a loan. The Federal Trade Commission warns that scammers often use language that targets people with bad credit. For example, “No hassle, guaranteed,” probably indicates a scam lender. Legitimate banks will only charge clearly disclosed fees, and they will deduct fees from the amount they lend to you. No legitimate bank guarantees that they will fund your loan.
If you have bad credit but still need a personal loan, consider taking these steps to increase your likelihood of getting approved for the loan.
- Find a cosigner. Signing a loan is a risky proposition for the cosigner. He or she agrees to make all the payments if you fail to make them yourself. Generally, we recommend not cosigning loans, but married couples with joint finances are an exception. If your spouse is willing to cosign your loan, you might be able to get a personal loan.
- Correct mistakes on your credit report. People with bad credit scores often will find mistakes on their credit report. You can report errors to the credit reporting bureaus and have your report fixed. If you’re not comfortable with the DIY approach to credit repair, consider hiring a reputable credit repair firm to help you. Once the errors are removed, your credit score should rise.
- Reduce existing credit card debt. While you’re shopping for a personal loan, take steps to drive down your credit card debt. These can include reducing your credit card utilization ratio by using your debit card rather than your credit card.
- Make on-time payments. The best way to increase your credit score is to make on-time payments on all your existing credit accounts. Over time, this will help raise your credit score more than any other technique.
- Don’t become desperate. If you have bad credit and you’re behind on bills, you may get caught in an unsustainable debt trap. Rather than resorting to taking out new debt, make an effort to negotiate settlements and payment plans with your existing creditors. When you have your debt situation under control, you may be able to qualify for a new loan to help you toward your goals.
Personal Loan FAQ
Should I Pay Off My Personal Loan Early?
In general, paying off a personal loan early is a savvy move if you can afford it. Before you make the move to liquidate the loan, save up a decent cash cushion for emergencies. With cash on hand, you can pay off the personal loan without the risk of having to take on high interest debt in the future.
In general, liquidating a personal loan early won’t hurt your credit score. Paying your personal loan on time gives your credit score a little boost each month, but paying off the loan won’t negatively affect a score that’s already good. As long as you have a current credit account — such as a student loan, an auto loan, or a credit card — your credit score should remain intact.
Can You Have More Than One Loan at Once?
Different lenders have different lending requirements on personal loans. LendingClub, a popular peer-to-peer lender, allows borrowers to have up to two active personal loans at a time. Other lenders may be fussier.
How Will a Personal Loan Affect My Credit?
Initially, taking out a personal loan will have a negative effect on your credit score. The credit inquiries will reduce your score by a few points, plus the additional debt increases your overall debt load.
However, if you use your personal loan to drastically drive down your credit card utilization ratio, you may see an immediate boost to your credit score. Even if you’re using your new loan to consolidate credit card debt, you should not close your existing credit card accounts. Feel free to cut up the cards, but closing the accounts will hurt your credit score.
No matter what you do, be sure to make on-time payments on your personal loan. This is the best way to increase your credit score. If you make payments as agreed, your credit score will rise over time.