This guide to personal loans will help you learn everything about this common type of loan so that you can make an informed decision. Let’s start with the basics before we dig deeper into interest rates, fees, and all the pros and cons of personal loans.
What Is a Personal Loan?
A personal loan is a lump sum of money that you borrow from a bank, credit union or a non-banking financial company (NBFC) to use for general purposes. Personal loans usually don’t require any collateral, which means that they are typically unsecured loans. Many lenders won’t even ask about the borrower’s purpose for getting a personal loan, while others will limit your possibilities, that is, restrict what you do with the received funds. In most cases, your lender won’t keep track of their use.
When you need cash for some specific purpose, these loans can be a very good idea. They come with fixed interest rates, a fixed repayment period, and fixed equated monthly installments (EMI). This means that you need to provide the same amount of money each month for a specific period of time until you pay back what you owe, and your interest rate won’t change during the entire loan term.
Once the repayment period is over, and you’ve paid back your loan in full, your lender will simply close your account. In case you need additional money, you would have to get another loan.
How Do Personal Loan Interest Rates Work?
Personal loans are amortized loans, which means that the lender applies scheduled regular payments, both the principal (the amount you borrowed) and the interest. Every time you make a payment, your principal goes down, and a portion of that payment goes to your interest.
To calculate your interest as your balance goes down, you need to look at your lower balance.
Before your first payment, divide your interest rate by 12 (a number of months in a year, since interest rates are always expressed on an annual basis), and then multiply it by your loan principal. For every subsequent payment, multiply your interest by your new balance. You’ll determine your new balance by subtracting the amount you paid back and the interest you covered from your loan principal.
Common Uses of Personal Loans
As you already know, you can use a personal loan for an array of different purposes. The options are almost infinite, as you can use it to cover any larger personal expenses you need. You can use it for purchasing a home or a car, renovating your home, paying for college, funding a wedding, paying for a family vacation, buying a PC or other cutting-edge tech device, covering unexpected medical expenses, or any other emergencies.
You can also use it for debt consolidation, such as paying off credit cards or any other debts you may have. Getting a personal debt consolidation loan means combining all your debts into a single loan. You would get a lower interest rate on all your debts, and you would need to provide fixed monthly payments for that one combined loan.
What Are Types of Personal Loans
There are two types of personal loans to choose from:
- Unsecured personal loans
- Secured personal loans
Unsecured Personal Loan
The unsecured personal loans are the most common types of personal loans. Unsecured means that they require no collateral, which means that the lender has no valuable asset to fall back on if you happen to default on your loan. This is exactly why personal loans are a bit difficult to get approved for, simply because they carry more risk for the lender. Every lender needs a guarantee that you will pay off your loan on time and in full. This is why they check your credit score and income level so that they can determine your repayment capacity.
If you do happen to default on an unsecured loan, and there’s no collateral for you to forfeit, the lender may take other actions to collect your debt. They may file a lawsuit or seek help from debt collectors. It goes without saying that they would report your loan default to the major credit bureaus, which would be devastating to your credit score.
Secured Personal Loan
On the other hand, secured personal loans are backed by collateral. Collateral can be your home, car, savings account, or any other valuable asset that you pledge as security for repaying your loan. You put up a particular asset as collateral to provide a guarantee that you will pay back what you owe on time and in full. Otherwise, the lender has the right to seize the asset.
Interest Rates and Fees
Interest rates are usually higher with personal loans. That is, they are higher when it comes to unsecured personal loans. Whatever type of personal loan you apply for, your interest rate will depend on several factors. It will be based on your credit score, income level, the amount of money you want to borrow, the tenure (repayment period) you choose, whether you have any unconsolidated debt, and other factors.
Depending on the lender, and all these other factors, interest rates for personal loans usually range between 5% and 36%. The better your credit score, the lower the interest rate you will get. The longer tenure you choose, the higher your interest rate will be. Whatever the case, you will get a fixed interest rate. All your monthly payments during the entire life of the loan will be equal.
Other Fees on Personal Loan
When it comes to other fees for taking out a personal loan, they depend entirely on the lender. Some lenders may charge you origination fees for applying for a loan. They include the cost of all the paperwork necessary to process and set up a loan.
- Origination. Origination fees usually range from about 1% to 8% of the loan amount, depending on the lender, your credit score, loan amount, tenure, the purpose of your loan, whether you apply with a cosigner, and other factors.
- Prepayment penalty. Other lenders may also charge you a prepayment penalty if you happen to pay off your loan before its repayment term is over. This is because early repayment prevents the lender from acquiring the interest that you would have provided if you had continued making payments for a longer period of time.
Personal Loan Repayment Period
Just as you will get a fixed interest rate for your personal loan, you will also get a fixed schedule for repaying your loan. You can choose your own repayment period or tenure, usually ranging from 12 to 60 months (12, 24, 36, 48, or 60). The longer repayment period you choose, the lower your monthly payments will be, but your interest rate will be higher. In contrast, a shorter repayment period means higher monthly installments, but also a lower interest rate.
If you set a longer tenure, you may limit your options for potential future loans or credit cards. However, setting a longer repayment period shows that you have a healthy repayment capacity. It shows that you can afford to pay off the loan with a higher interest rate. It improves your eligibility and enables you to get approved for the loan faster. However, if you go down this path, make sure you can actually afford it. Make sure you can provide on-time, full payments every month for the entire life of the loan.
Qualifying for a Personal Loan
To qualify for a personal loan, you first need to have a good credit score. Most lenders disclose on their website the minimum credit score necessary for qualifying for their loans. Of course, you can always ask them directly. If you happen to have a poor credit score, you may still be eligible for a secured personal loan. In that case, you will need to put up certain collateral to get approved.
To determine your loan eligibility, your lender will also require proof of employment and your income level. You need to have a steady job with a steady income to show that you can afford to repay your loan. They will also calculate your debt-to-income (DTI) ratio to determine your ability to provide monthly installments on time and in full. They will do so by comparing your desired loan amount against your income and spending habits.
5 Benefits of Personal Loans
If a personal loan is the right type of loan for your needs, it can be a good idea to apply for it for several reasons.
- Flexibility of Use. You can use a personal loan for pretty much anything. From large purchases, home renovations, and funding a higher education, to covering travel expenses, medical bills, and any other unexpected or urgent expenses you may encounter.
- No Collateral. As personal loans are commonly unsecured, you don’t need to put up any collateral as security. This is what a lot of people find most appealing when personal loans are concerned. Of course, you can also get a secured personal loan that’s backed by collateral.
- Utilizing the Loan Even If You Have Bad Credit. If you have bad credit, you may still be eligible for a personal loan. You can get a secured personal loan that you will back with collateral.
- Fixed Payments. Personal loans come with fixed interest rates, and you need to provide fixed equated monthly installments over a fixed period of time. No rate or payment amount changes during the entire life of the loan.
- Setting a Repayment Period That Suits Your Needs. With these loans, you can set the tenure that fits your needs. You can choose from a period of 12, 24, 36, 48, and 60 months to repay your loan.
2 Drawbacks of Personal Loans
As much as personal loans can be beneficial, they do come with certain drawbacks that you also need to consider.
- You Typically Must Have a Good Credit Score. Personal loans usually require a good credit score. Luckily, you can get a secured personal loan if you have a poor credit history. However, not every lender will give you the option to get a secured loan. Of course, you can shop for other deals, but what if you don’t want to get a secured loan? What if you don’t have any valuable assets to put up as collateral? This is why personal loans may not always be a great idea for people with bad credit.
- Higher Interest Rates. These loans typically have higher interest rates. However, this is the case when they are unsecured. You can get a lower interest rate if you opt for a secured loan type or if you have a very high credit score that you can leverage. You can also lower your interest rate if you’re looking for a higher loan amount, or if you choose a shorter repayment period. However, there are other factors that impact interest rates. If they don’t get you a lower interest rate when they add up, you may not find this type of loan very appealing.