How Personal Loans Work

What are personal loans for?

There are several reasons an American today may want to get access to borrowed money. In 2020, according to Trans Union, one of the three main credit reporting agencies in the U.S., 21.1 million people had an outstanding personal loan. In the last decade the submitted number of loans has largely increased, thanks to a smoother and faster process of obtaining money, made possible by online lenders, who tend to offer more favorable conditions in comparison with traditional banks. According to a 2019 survey of Lending Tree, a leading marketplace of lenders, personal loans among its customers are made for the following reasons.

Debt consolidationCredit card refinanceOtherHome improvementMajor purchaseMedical billsMoving and relocationVacationWedding expenses

Even those accounting with the lowest percentages equal millions of Americans demanding a loan.

In a nutshell, you may want to consider a personal loan for:

  • Debt consolidation: it is quite common practice to put multiple lines of credit (for instance credit cards) under a unique personal loan with a lower interest rate, with the further advantage of having more control on own budget
  • Home improvements: many homeowners need some major renovation during their house lifetime, but not always have the ready availability to finance such projects. These are beneficial also because making rise the value of the property, alias adding home equity
  • Emergency expenses: it is legit borrowing to face unexpected costs that can be detrimental to your monthly budgets, like repairs or medical bills
  • Big purchases: you may for instance need a new appliance or household item (computers, hoovers, etc.), replacing the roof, buying a car, or take a vacation wished for a long-time
  • Events: one-time life occurrences such as a wedding, divorces, or funerals.

A personal loan will give you the money otherwise you couldn’t have access to it, at least within the timeframe of necessity. It is generic, which means you can use this type of loan for almost anything; however, there can be special needs such as tuition which, for their characteristics require a dedicated type of financing (student loans). Another example of specificity are business loans: while personal loans have relatively high limits, these might just not be enough for borrowers who need money to support their businesses.

You can get personal loans from credit unions, banks, or private lenders, which are divided into companies, marketplaces, and peer-to-peer lenders.

Regardless of the source, modalities are the same: personal loans are given in a lump sum, that will be accredited directly on your bank account or by check, and repaid typically with fixed-rate installments over a certain number of years, meaning that your interest rate (APR) will stay the same for the whole period of the loan agreement; repayments are made usually on monthly basis. Lenders can offer to choose a variable rate: the advantage is having low interests than average to start with, but very likely to rise later according to the market variability; anyway, there will be a cap for the maximum rate percentage allowed to apply.

A personal loan is normally unsecured, meaning that you don’t submit anything as a guarantee for the lender that you will pay off the debt (unlike mortgage where your home itself is the collateral), and is set to a relatively short term, averaging from 2 to 5 years; limits are typically lower than the ones set on secured loans. For compensating the risk, lenders will also charge a higher APR than with a secured loan and will take more into consideration a borrower’s credit profile.

Secured personal loans are options rather than the norm, that are generally chosen when one couldn’t otherwise qualify: you get lower interests, but would usually put your car or savings as warranty assets that lenders have the right to claim against the borrower’s possible default on due repayments. In some cases, it is possible to convert an unsecured into a secured loan operation.

In order to qualify, you must demonstrate your financial status: lenders set your interests looking mainly at credit history (and score) that speaks of your reliability as a debt payer, as well as your income (how much it is, if it comes from a steady source, years of employment), other assets you have, eventual legal issues so that they can predict if and to what extent you will be able to return the money lent.

Whenever you get a personal loan, there is typically a fee that will be subtracted from the amount borrowed, namely the origination fee, which is a smooth percentage (an average of 3,5%) of the loan amount: for instance, if you apply for $10,000, assuming that average, you will actually get $9,650. If you need exactly the sum for which you applied, your loan should be $10,350. Other duties to check for are late payment fees, and prepayment penalty fees if you decide to settle up too early toward the arranged term.

Each lender has different funding times, which could be a crucial aspect to consider if you have some kind of urgency. Regardless of the creditor choice, you will get the needed cash in a matter of days.

Is a Personal Loan the right option for you?

If you are facing expenses that require quickly a unique sum not temporary available, while being confident with your ability to repay that amount (plus the interests) over a number of monthly installments in a few years to go, then you should consider a personal loan.

A frequent scenario may be the following: you are a fresh homeowner in the very first years of mortgage with an active insurance policy on the house, so you have faced substantial costs; at some point you run into incumbent needs, such as an emergency repair, consolidation of credit cards debt, or to pay medical bills. With a personal loan, you can amortize these expenses probably better than with taking on other types of loans.

However, it is not generally recommended to embark on such a debt for financing necessities other than basic ones, for which you could save up, like buying vehicles or for vacation. Lenders will anyway look at your debt-to-income ratio to prior determine if you can actually qualify for a loan, and for which interest rate; your credit score has to be the best possible.

Essentially, you have to consider how much APR you can withstand: despite being “annual”, the rate will of course apply to each monthly payment. When you think about how personal loans work, you have to take into account that they tend to have lower APRs compared to interest rates for credit card borrowing, and they are more likely to remain fixed over the loan term (sometimes, market variations might impose a change to fixed rates), but come with fees that you have to pay upfront.

With credit cards, you might have zero interest for a certain time span, but if at the end of this period you have pending debt, an higher than normal APR will apply. If you were looking to consolidate debt, you may put yourself into another debt, provided some calculation is not done before.

Choosing one or another type of loan is all about dealing with the repayments: some loans are more advantageous in the short term while having drawbacks in the long run and vice versa.

How Personal Loans Work: Pros & Cons

Pros of personal loans

• You obtain money fast, one lump sum within as little as 24 hours

• In most cases, they are unsecured loans, which means you don’t risk important assets if failing to make the payments

• Interest rates are lower than other credit sources like credit cards or “payday loans”

• You have an affordable timespan to repay the borrowed sum, generally from 1-7 years depending on lenders

• You might be allowed to have a co-signer, who accepts to dispose of his/her credit score to support your loan

Cons of personal loans

• You are basically taking a debt, on top of other potential existing ones

• There can be fees due to the lending service in itself like origination, late and early repayment fees, besides the declared APR

• Rates are higher than with secured loans, for instance in comparison to car loans and mortgages

• Many lenders can deny a personal loan if your credit score is too low.

Other things to consider

Credit cards can be a viable alternative to borrow money, but the maximum limit amount you can get is lower in comparison to a personal loan; moreover, when using credit cards some people tend to go overboard with spending.

Your actual credit score might be an issue: if it’s lower than expected by the lender but you need that loan soon, you can temporary relying on a co-signer (who could be a relative of yours) having good credit him/herself; then, taking time for adequate measures to make the credit going up.

It is of utmost importance, and common sense, to evaluate your overall financial condition if deciding to apply for any loan. If you are borrowing to extinguish debt, you are creating another debt indeed, so make sure it is a major burden you are going to lighten from, and the time span it takes will be the shortest possible.

How much are personal loan rates?

If you came to the decision that a personal loan is right for you, consider a marketplace of lenders and borrowers when you have multiple choices to evaluate, according to your conditions.

Everywhere, you will find the acronym ‘APR‘, i.e. the annual percentage rate: it results (in its wider definition) as the total of the interest rate plus charges and fees for the financial service itself; these are origination fees, closing costs, or eventual broker charges. However, it is up to the borrower to always verify the single lender conditions: again, fees may be set apart, adding up to the cost of APR.

APR is calculated also in function of the loan term, and is the most relevant factor to consider since it dictates how much you are going to re-pay over the sum you borrowed: the lowest APR is of course the better, unless for a higher one you are offered conditions of payment more suitable for your situation, for instance yearly instead of monthly scheduling of installments. To determine your best deal, you still have to check APR against the origination fee, as well as the other eventual levies.

To recap, three are the main attributes of a personal loan:

  • APR
  • Term
  • Max loan amount (limit)

Among a plethora of lenders on the market, the range of APR goes from roughly 6 to 36%. Your credit score and history will greatly this rate percentage: you will obtain a lower interest as your rating is higher; a certain minimum score is a relevant eligibility criterion, and you will find differing requirements depending on the company.

There is virtually room for every credit score to access a loan, but conditions will be more and more difficult, as rates will be higher than normal. Usually, for every lender, you can see offers either with an interest fixed to its lowest, or ranging. Generally, we found that you may expect an APR in the range of approximately 10-15% if you have a “good” to “very good” score, while from 17.5 up to 36% whether it is fair, poor, or bad credit. An ideal APR is anything under 10%, which applies only to borrowers with exceptional scores.

A personal loan term is most commonly between 1 and 7 years (possibly up to 10 years ), with timespans varying depending on the lender. Limits of the loan are the maximum you can borrow: the cap for a personal loan is $100,000, but not every lending company can grant it; for most people, a $40,000 limit is likely to be enough. Beyond these limits, the loan will have to structure itself to accommodate the precise purpose for which is made: a business loan of $500,000 is still a “personal” type of credit, but can’t have the same term and rates.

How to get a personal loan?

Following the traditional way means asking your bank for funding, but in the last several years it has become difficult to obtain a loan from banks for a bunch of reasons.

This can be bypassed by turning to a reliable online provider: nowadays the choice is ample, but the golden rule is to choose established, solid names in the industry. Then you will have to look at low interest rates, as well as transparency of terms and conditions.

There is the possibility that you won’t be approved: independently by the lender you choose, you must provide documentation stating that you receive enough and consistent income from your job, that you haven’t already significant debts, but, if you have, that you are a punctual payer. Keep in mind that every lending company considers in a slightly different manner how much each financial parameter is relevant: this relates especially to interest rates. If you are approved, you have to consider at a very minimum 24 hours of business days before being accredited with the sum asked; the time necessary will vary depending on the lender.

Comparing personal loans

The best thing to do to obtain the most comfortable loan offer is to shop around multiple lenders, after having ascertained the real necessity for the loan. Your choice will be a trustworthy lender who:

  • offers low interest rates (APR)
  • has reasonable fees
  • provides a comfortable experience overall

A great way to do this is by using marketplaces or peer-to-peer lenders. A personal loan has to be the right fit for you, and you must afford the monthly repayments for the whole loan duration. As mentioned, APR is the most important element to factor. If not included in it, origination and other fees must be taken into account, in fact, you probably don’t want to pay too much upfront, sacrificing the real amount borrowed.

Last but not least, you may desire a certain degree of comfort, that is to say not too stringent deadlines or forbearance in case of financial hardship unexpectedly occurring in the loan period. That’s how personal loans work.

Most lenders give the chance of a pre-qualification through a “soft” credit check, which means your credit score won’t be affected. This is the actual process that allows you to view all the conditions associated with the loan.

In a personal loan, you may also seek extra features such as setting auto-payments and discounts offered for things like loyalty, being a category of professional, etc. Some lenders are more flexible about paying-off options, while others may only allow prefixed timed payments, discouraging being late.

We accurately chose a variety of direct lenders, and companies working with networks of multiple lenders, basing our assessment on an optimal ratio between their presence in the loans industry and customers’ satisfaction.

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