This guide to personal loans will help you learn everything about this common type of loan to 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 from a bank, credit union, or non-banking financial company (NBFC) for general purposes. Personal loans usually don’t require any collateral, meaning they are typically unsecured. 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.

These loans can be an excellent idea when you need cash for some specific purpose. They come with fixed interest rates, a fixed repayment period, and fixed equated monthly installments (EMI). This means you must provide the same amount each month for a specific time until you pay back what you owe, and your interest rate won’t change during the entire loan term.

Once the repayment period ends and you’ve paid back your loan in full, your lender will close your account. If you need additional money, you would have to get another loan.

PRO Tip
If you’re thinking about getting a personal loan, make sure you can actually afford it. If you happen to default on your loan, it would severely hurt your credit score. Even one missed payment would stay on your credit report for 7 years.

How Do Personal Loan Interest Rates Work?

Personal loans are amortized loans, which means that the lender applies for 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.
You need to look at your lower balance to calculate your interest as your balance goes down.

Before your first payment, divide your interest rate by 12 (the number of months in a year since interest rates are always expressed annually), 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 various purposes. The options are almost infinite, as you can use it to cover any more significant personal expenses you need. You can use it to purchase a home or a car, renovate your home, pay for college, fund a wedding, pay for a family vacation, buy a PC or other cutting-edge tech device, cover unexpected medical expenses, or any other emergencies.

You can also use it for debt consolidation, such as paying off credit cards or other debts. 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 need to provide fixed monthly payments for that one combined loan.

PRO Tip
Before taking out a personal loan, make sure you really think about why you need the money in the first place. Perhaps some other type of loan will better suit your needs. Think about your current financial situation, too, so that you can determine what type of loan you can actually afford.

What Are the Types of Personal Loans

There are two types of personal loans to choose from:

  • Unsecured personal loans
  • Secured personal loans

Unsecured Personal Loan

Unsecured personal loans are the most common types of personal loans. Unsecured means they require no collateral, meaning the lender has no valuable asset to fall back on if you default on your loan. This is precisely why personal loans are difficult to approve; they carry more risk for the lender. Every lender must guarantee you will pay off your loan on time and in full. They check your credit score and income level to determine your repayment capacity.

If you 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. They would report your loan default to the major credit bureaus, which would devastate 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 guarantee that you will repay what you owe on time and in full. Otherwise, the lender has the right to seize the asset.

PRO Tip
If your poor financial history doesn’t enable you to qualify for an unsecured personal loan, you can ask for a secured personal loan. But if you do, make sure you can actually afford it first, so that you don’t have to worry about forfeiting the asset you put up as collateral.

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 loan’s entire life will be equal.

Other Fees on Personal Loan

Regarding 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 you would have provided if you had continued making payments for a more extended period.
PRO Tip
If you want to get a lower interest rate on your personal loan, you can always apply for a secured loan. Whatever type of loan you apply for, make sure you carefully consider all the costs that come with the loan and not just the interest rate. That way, you’ll know exactly how much money you will need to pay back.

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 repayment period or tenure, usually 12 to 60 months (12, 24, 36, 48, or 60). The more extended 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 and a lower interest rate.

Setting a longer tenure may limit your options for potential future loans or credit cards. However, setting a longer repayment period shows you have a healthy repayment capacity. It shows that you can repay the loan with a higher interest rate. It improves your eligibility and lets you get approved for the loan faster. However, if you go down this path, ensure you can afford it. Ensure you can provide on-time, full monthly payments for the loan’s entire life.

Qualifying for a Personal Loan

You must have a good credit score to qualify for a personal loan. Most lenders disclose the minimum credit score necessary for qualifying for their loans on their website. Of course, you can always ask them directly. You may still be eligible for a secured personal loan if you have a poor credit score. In that case, you must put up specific collateral to get approved.

Your lender will also require proof of employment and income level to determine your loan eligibility. You need a steady job with a steady income to show that you can 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 compare your desired loan amount against your income and spending habits.

PRO Tip
To increase your chances for qualifying for a personal loan, make sure you check your credit report for potential mistakes, pay off any debts you may have (unless you’re applying for a debt consolidation loan), and ask to borrow what you can afford to pay back. Make sure your debt-to-income ratio is lower. If your credit score is not so good, take a bit of time to improve it.

5 Benefits of Personal Loans

If a personal loan is the correct type of loan for your needs, it can be a good idea to apply for it for several reasons.

  1. Flexibility of Use. You can use a personal loan for anything from large purchases, home renovations, and funding higher education to covering travel expenses, medical bills, and any other unexpected or urgent expenses you may encounter.
  2. No Collateral. As personal loans are commonly unsecured, you don’t need to put up any collateral as security. Many people find this most appealing when it comes to personal loans. Of course, you can also get a secured personal loan backed by collateral.
  3. Utilizing the Loan Even If You Have Bad Credit. You may still be eligible for a personal loan if you have bad credit. You can get a secured personal loan that you will back with collateral.
  4. Fixed Payments. Personal loans come with fixed interest rates, and you must provide fixed equated monthly installments over a fixed period – no rate or payment amount changes during the loan’s entire life.
  5. Setting a Repayment Period That Suits Your Needs. With these loans, you can set the tenure that fits your needs. You can choose from 12, 24, 36, 48, and 60 months to repay your loan.

2 Drawbacks of Personal Loans

Personal loans can be beneficial, but they come with drawbacks that you must consider.

  1. You Typically Must Have a Good Credit Score. Personal loans usually require a good credit score. You can get a secured personal loan if you have a poor credit history. However, not every lender will allow you 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 an excellent idea for people with bad credit.
  2. 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 want a higher loan amount or choose a shorter repayment period. However, other factors impact interest rates. You may not find this loan appealing if they don’t get you a lower interest rate when they add up.

Frequently Asked Questions