You've probably heard of personal loans, either on TV or radio commercials. Some banks advertise them as debt consolidation loans, while others may suggest them to pay for elective medical procedures.
Personal loans are a unique type of debt product with their own features. They can be used responsibly, like to start a business, or irresponsibly, like to finance a vacation. Before you apply for a personal loan, read below to see what you need to know and how to find the best loan for you.
What Is a Personal Loan?
A personal loan is a type of consumer loan that is used for a variety of purposes. People take out personal loans to pay for weddings, home renovations, vacations, private school tuition, medical procedures and more.
People often use personal loans for debt consolidation, such as paying off credit cards. If, for example, you have credit card debt at an APR of 18%, you will save hundreds or thousands of dollars if you take out a personal loan at an 8% interest rate and use that money to pay off the credit card debt.
Personal loans, sometimes called signature loans, are unsecured loans, which means they don't have any collateral behind them. An auto loan or a mortgage is a secured loan because the lender can repossess the property if the borrower defaults. Student loans or payday loans are another form of unsecured loan.
Because a personal loan is unsecured, interest rates are higher than they would be for a secured loan. Current rates for personal loans range from 4% to 36%, depending on the amount of the loan, the term or length of the loan, and the borrower's credit scores.
Lenders can offer loans with fixed or variable interest rates. A variable-rate loan will have a lower starting rate but can increase if the Federal Reserve raises interest rates. A fixed-rate personal loan will have the same interest rate throughout the loan's term. Personal loans range from $1,000 to $50,000, and most terms are between two to five years long. When you take out a personal loan, the bank can usually wire the funds within a day or two of approval.
How to Compare Personal Loans
When taking out a personal loan, borrowers should compare rates and terms from multiple banks and lenders. Each one will have its own interest rate ranges, so it's best to shop around. Interest rates will also vary based on the length. A two-year loan will typically have a lower rate than a five-year loan.
Compare the fees, including origination, prepayment, and late fees. A prepayment fee is a fine the banks charge if you repay the loan early. If you plan to do that, avoid taking out a loan with a prepayment fee. The origination fee, usually around 2% of the loan, is what the bank charges to complete the loan. Origination fees vary from lender to lender, so be sure to shop around and know the cost of the loan before you sign on the dotted line.
If you already have a bank you like, talk to its lending officer about your options. You might find a better rate there than at a new bank. Look at rates for online lenders as well as brick-and-mortar ones.
When Is a Personal Loan a Good Idea?
Taking on more debt is almost never a good idea, especially if you're using it for a trip to Paris or an engagement ring for your girlfriend. But a personal loan is often a great way to save money on interest if you have credit card debt.
Debt consolidation is the best reason to open a personal loan, especially if you have an excellent credit score. Credit card rates are some of the highest in the industry, and if you can avoid paying above 15% APR, you should. Plus, credit card balances don't have a set deadline if you only pay the minimum. A personal loan has a set payoff due date, which is better for consumers who tend to have a hard time paying off credit card debt.
How to Qualify for a Personal Loan
If you want to apply for a personal loan, you'll need the following:
Low Debt-to-Income Ratio
Banks want to know that you can afford to make your monthly payments before they give you another loan. If your ratio of debt-to-income is too high, they might be wary of lending you more money.
Think of it this way. If you already owe $1,000 a month in various loans and make $2,000 a month, 50% of your income goes toward those payments. If you take out a personal loan with a $300 monthly payment, now 65% of your income will go toward debt. That makes it hard to keep up with payments if you lose your job or have a major medical emergency.
Good or Excellent Credit
Banks want to see good credit from customers. The higher your credit scores, the less you'll pay in interest and the better chance you will have of qualifying for a loan. You might be able to find lenders who will accept a 600 FICO® score, but 700 FICO® score or above is better.
If your work is sporadic, a bank will have a hard time lending you money. Stable income means you have consistent cash flow and can afford to make your payments every month.