The basics of Personal Loans
When shopping for a personal loan, the two most important factors are choosing a reputable lending partner and finding a low interest rate. We’ll soon have first part covered here – our experts are working on identifying the lending partners that are the top choices for factors like avoiding hidden fees and providing good customer service.
Interest rates will vary for everyone based on criteria like credit score and income, so make sure you shop around to find the lowest rates for you.
Millions of consumers have used personal loans to refinance high-interest credit card debt, pay off household bills, or simply divide a large expense into monthly payments that fit their budgets.
A personal loan offers more flexibility than virtually any other type of loan because you can use them for many things, from car repairs to a bathroom remodel, making them a go-to solution for when you simply need cash to make ends meet. Here’s what you should consider when taking out personal loans, to help you make a decision that fits your financial needs.
What is a personal loan?
Personal loans are defined by two basic characteristics. First, personal loans do not require collateral, in contrast to a car loan, which is backed by the value of your car, or a mortgage, which is backed by the value of your home. Secondly, a personal loan is an amortizing loan, meaning the balance goes down every time you make a payment, eventually repaying your balance in full.
Personal loans are typically used for two main purposes:
- Paying for personal expenditures — The good thing about personal loans is that they can be taken out for virtually any reason. Some common reasons include making home improvements, paying for car repairs, or to pay for a vacation.
- Refinancing existing debt — Personal loans are excellent for refinancing high-interest debt at a lower interest rate. For example, it can make sense to use a personal loan to consolidate and refinance high interest credit card debt. Reducing your interest rate from a common credit-card APR of 20% to a personal loan rate of 10% or less can save you a fortune in interest.
Personal loans are very common. In addition to traditional banks, there are also many different online loan providers where you can apply for a personal loan and get an instant or nearly-instant decision on whether or not you qualify for a personal loan for your specific needs.
Applying online for personal loans
The process of applying for a personal loan is pretty straightforward. The lending partner will ask for pertinent information about you, including how much you earn, how much you spend on rent or mortgage payments, where you live, and how much you’d like to borrow. Some may also ask for bank statements and other financial forms.
The lending partner decides whether or not to approve you for a loan, and what interest rate you’ll pay, based on information you supply to them. After approval, the step-by-step process goes a little like this:
- You receive your loan disbursement — Some lending partners do this by check, but most now simply send the money to your checking or savings account via electronic transfer, which puts the money in your account in as little as 24 to 48 hours. The speed at which you can get approved for a personal loan and get access to the amount you borrow is one of their biggest perks.
- Repayment — Personal loans typically require monthly payments to repay your balance. During the repayment period, you will be responsible for making a consistent monthly payment to repay your balance over time. For example, a £5,000 36-month loan at an 8% APR would require monthly payments of £156.68 every single month. After 36 months, the loan will be repaid in full, and you won’t need to make any additional payments. Tip: Some lending partners may give you a discount on your interest rate if you agree to automatic drafts from your checking account to pay your loan each month.
- Payoff — When your loan is paid in full, you’ll receive a payoff notice declaring that your loan has been repaid. If you’d like to pay loan off earlier than originally planned, speak to your lending partner. While it may seem like lender would be happy to get the money back early, it’s actually a bit more complicated. Depending on the original agreement, there may be fees involved in an early payoff, though some agreements allow for fee-free early payoffs.
Why get a personal loan?
Getting a personal loan can be a good idea if you need financing for a certain purchase or expense that cannot be financed less expensively with a traditional secured loan. Here are the three occasions in which it makes sense to consider a personal loan.
- You need cash for a personal expense. If you need to borrow money to buy a car or home, there are loans specifically designed for those needs. But if you need money for moving expenses, a wedding, credit card consolidation, home improvements, or a myriad of other personal expenses, a personal loan is often the only way to borrow the money you need.
- You want to refinance high-interest debt. Personal loans can be an excellent way to reduce the interest you pay on a debt, and the monthly payment required to pay it off. While the average credit card carries an interest rate of 20% or more, many people qualify for personal loans with rates in the single digits.
- You need more time to repay. The advantage of personal loans is that they offer repayment terms as long as five years for qualifying borrowers. While a 0% intro APR credit card may be a better option if you just need a few months to pay off a balance, a personal loan may make more sense if you need more time to pay off your balance. A 0% intro APR credit card will reset to a much higher interest rate after the promotional 0% APR expires.
Unsecured personal loan rates
Interest rates on a personal loan vary based on your income, credit score, and how long you want to borrow the money. Low-APR personal loans for people who have excellent credit can carry interest rates as low as 3%, while borrowers who have bad credit will pay as much as 35% per year in interest.
You will pay a higher rate on a personal loan than you’d pay on a car loan or mortgage, but the rate should be lower than the rate you’d receive from other unsecured loans like credit cards.
The reason for higher rates is pretty straightforward: Car and mortgage loans are secured by the value of your car or home. If you don’t pay them back, the bank can repossess your car or your home, sell it, and recoup some of the money.
However, if you don’t repay a personal loan or credit card, there isn’t any collateral for the bank to repossess to recoup some of the losses. Thus, an unsecured personal loan is much riskier for lending partners than secured loans, which is why they carry higher interest rates.
Of course, a comparatively higher interest rate doesn’t make a personal loan a bad deal. Many people use personal loans to refinance high-interest credit card debt, or to finance a major purchase or expense in a less-expensive way. Below, we calculated how much you can save by financing a £5,000 balance on a credit card at 20% or using a 3-year personal loan at a lower APR.
|Credit card APR
||Personal loan APR
||Interest saved over 3 years
As you can see, personal loans can save you a relative fortune in interest compared to the typical credit card, even on a relatively small balance of £5,000. The advantage of a lower APR is that more of your payment goes toward paying down your debt, which means you’ll make more progress toward being debt-free every single month.
Here are few things you should know before you start shopping for an online personal loan:
- Origination fees matter — Technically, an origination fee isn’t interest, but it does add to the cost of the loan. An origination fee of 0% to 5% is common, which means you can expect to pay a fee of up to £250 on a £5,000 loan, which will be added to the balance, or subtracted from the loan proceeds. Luckily, the APR you see quoted for a loan includes interest and fees. So, a loan with an APR of 7% is less expensive (interest and fees included) than a loan with an APR of 8%. You may be eligible for a no-origination-fee personal loan if you have a prime credit score (720 or better).
- Rates vary — The same person could apply for a personal loan from two different lending partners and get two vastly different quotes. Likewise, the same bank may quote different rates for the same applicant depending on when they apply. The point is that it can pay to shop around, as lending partners are constantly adjusting their rates and terms. A lending partner that has the lowest APR today might not have the lowest APR a month from now.
- It pays to consider your options before applying — Many people fear that shopping around for rates will hurt their credit scores when the inquiries start showing up on their credit reports. And this fear isn’t unfounded. When you apply for a loan, the lender will perform a “hard” credit check, which shows up on your credit report. Do too many of these in a short period of time, and it make it increasingly hard to get any sort of credit-based product – whether it’s a loan, mortgage or credit card. For that reason, it pays to do some research ahead of time, and apply for a loan for which you feel confident you’ll be approved.
How to get a personal loan with bad credit
Because personal loans aren’t backed by any collateral, credit scores play an important role in whether or not a bank will approve you for a loan. Having bad credit will make it more difficult to get approved, but not impossible.
Here are a few tips and tricks that can make it easier for you to get a personal loan, even if your credit is far from perfect.
- Get a shorter-term loan — Loans that are repaid in a shorter period of time are simply safer for the lending partner than longer-term loans. If you have bad credit, you may find that it’s easier to get approved for a 24-month loan instead of a 48-month loan, for example. A shorter loan term will increase your monthly payment, so it’s doubly important to borrow only as much as will fit in your budget if you go this route.
- Be selective with applications — Lending partners don’t want to waste your time. For that reason, if you have an Experian Credit Score of 600, it’s a bad idea to apply for a lender who requires a credit score of 800. Focus your time on lending partners who specialize in online personal loans for bad credit instead.
- Pay down small balances — It can make sense to clean up your credit report before applying for another loan. It’s often better to have one £500 balance on one credit card than to have 10 cards, each with an outstanding balance of £50. Try to keep your balances on any existing credit lines like credit cards down to 30% or less of your available credit. That means that if you have a card with a £1,000 credit limit, it would be ideal to have a balance of less than £300 on it. (Your balances are only reported to the credit bureaus once per month, so this isn’t an instantaneous fix.)
- Get a cosigner — If you have bad credit, you’ll find it’s easier to get a personal loan with a cosigner. Since the cosigner is legally responsible to repay the loan if you cannot do so, a lending partner will often make the decision based on the cosigner’s creditworthiness or income rather than yours. Of course, the consigner takes a lot of risk by putting their name on your loan, so finding a good cosigner can be hard to do. (Joint personal loans, where two people are named as borrowers, can also offer lower rates and better approval odds.)
Is a personal loan right for you?
We put together a short decision tree to help you decide if a personal loan is right for your situation. If all of the following statements apply to you, then a personal loan could be the best way to borrow money for your financial needs.
- You need more than a year to repay. Personal loans can be repaid over periods as long as five years, making them a good source of medium to long-term financing. If you don’t need as much time to repay, a 0% intro APR credit card may be a better way to finance a purchase or expense.
- A specific loan doesn’t exist for your needs. It would be silly to take out a personal loan to buy a used car, for example, since car loans have much lower rates than personal loans. But for expenses that fit the definition of a personal expenditure, a personal loan is a good fit.
- You want to refinance high-interest debt. The single best reason to use a personal loan is to consolidate and gradually eliminate higher interest debt. Paying off a £5,000 credit card balance at an 18% with a personal loan at an 8% APR could save you about £867 in interest over a three-year repayment period, for example. Personal loans are a great way to refinance any unsecured debts at a high interest rate. To refinance debts to repay them over a shorter period (one year or so) a balance transfer credit card with a 0% intro APR may be a better choice.
- You aren’t borrowing to spend frivolously. Just because you can get a personal loan to buy a 100 inch TV with a £5,000 surround-sound speaker system doesn’t mean you should. A personal loan shouldn’t be used to spend beyond your means, as it’s easy to get trapped in a cycle of borrowing at high interest rates to make purchases that you could
The Motley Fool receives compensation from some advertisers who provide products and services that may be covered by our editorial team. It’s one way we make money. But know that our editorial integrity and transparency matters most and our ratings aren’t influenced by compensation. The statements above are The Motley Fool’s alone and have not been provided or endorsed by bank advertisers.