Table of Content
What is a Personal Loan?
At some point in time, you may find yourself considering getting a personal loan. It may be because you need money for a new car, a wedding, a family vacation or simply to pay off some debts. It is of utmost importance that you get your hands on the essential information about personal loans before you decide.
The fact is, when you search for a personal loan, you may find hundreds of different loans on the market from different lenders.
That is because lenders package personal loans to address the different needs of different borrowers. So, in order to optimize your loan, you have to understand how a particular personal loan product will solve your need. This guide aims to provide you with many important loan facts so you can make a better choice.
More Than Financial Contract
Technically, a loan is a financial contract involving two parties called the lender and the borrower. Under this contract, the lender will agree to give the borrower a specific amount of money with the understanding that the borrower will pay back the money over an agreed period of time. It is usually, a fixed amount every month together with a pre-determined interest and occasionally, extra charges for loan administration. The other details will vary from each lender but the loan contract will spell them out – most particularly the repayment dates and interest charges.
You may encounter many different personal loan names and products from different lenders. However, you can classify personal loans into just two main types: secured and unsecured loans. The obvious difference is whether the lender will require a security for the loan. In a secured loan, the borrower must provide an asset such as his house, as a collateral for the loan. In an unsecured loan, the lender will not ask for such a requirement as long as they have satisfactory credit and are currently employed or have a regular source of income.
In this chart using TransUnion data, we can see that the number of individual personal loan borrowers has steadily increased:
Things You Should Know Before Taking a Personal Loan
Times have changed even in the way people get a personal loan. In the past, lenders will just focus on your credit scores (See how your credit score is calculated), examine your tax returns and check your employment details before they grant you a loan and if so, at what interest rate.
Today, we are seeing a breed of new lenders who are veering away from tradition in their decision-making processes. Most often, they will look at non-traditional indicators like your SAT scores and your social media accounts.
They will use this information to help them decide whether to give you a loan and how much interest rate to charge your loan. Consequently, this has helped to get a loan much easier than when people used to apply for loans from credit unions and traditional banks – the two institutions that hugged the personal loan arena.
Personal Loan Basics
Personal loans can be as dynamic as their borrower’s purpose in terms of their principal amount and length of their term. Some personal loans can run for years while other loans, like payday loans, become due in just a couple of weeks after the lender releases the money. In a payday loan, if the borrower repays the entire loan during that short period, he wouldn’t have to pay interest but will most like pay an origination fee for it.
In this chart compiled with LendingTree customer data, you can see that those with a 720+ credit score pay an average of 7.63%. At the other end of the scale, for those with a poor credit rating of less than 560, the rate shoots up to an eye-watering 113%.
There are some forms of personal loans that begin to accrue interest immediately – such as an installment loan. The size of the loan and the interest rate of the loan will dictate the borrower’s monthly payment. In some cases, when a borrower opts for a longer term, the lender may give him a lower interest rate.
If you have trouble making computations, you can use a good loan calculator. You can check whether it will be more advantageous for you to choose a longer term with a lower rate or a shorter term but with a higher rate. Just keep in mind this piece of advice: borrow within your means and never borrow more than you can afford to pay.
Here are 9 Things You Should Know Before Taking a Personal Loan:
1. Consider Your Needs – NOT Your Eligibility
Don’t take out a personal loan just because you want to and are able to. If your intention is to invest the money in stocks or commodities, borrowing is not the way to go. Personal loans are for real needs like marriage or college. It will also be more difficult to get one if you are not very clear on what to do with it.
A personal loan ranks in the higher end of the list of most expensive debts. Would you really want to pay interest on money that you don’t actually need? Don’t fall for the flowery words of the loan agents when they try to convince you that you’d be better off borrowing more. Remember to borrow only as much as you need and not a dollar more.
2. Have All Your Information Ready
Personal loans are simple – they are not nearly as rigorous as mortgage applications. You won’t need tons of paperwork, appraisals, and other meticulous documentation but you still need to make sure that you have the right information on hand. This will make your application and approval a lot easier.
Online lenders allow borrowers to apply for loans in as short as 15 minutes and then receive an approval within minutes. Some companies, such as Discover, will even let customers pre-check whether they can get a loan and know their rates before formally lodging an application.
Now, it doesn’t matter where you will apply for your loan, but the standard requirements are your Social Security System, proof of income and tax return information. All lender want to make perfectly sure that you’ll be able to pay your loan so they want to see how you make a living and that you do not owe any money to the government. Have this information ready before you apply.
Once your financial documents are in order, the lender can decide quickly so expect the decision a few days after you have filed your application. And since you already know what to do before applying, the process won’t have to be too troublesome for you and hopefully, you will be successful.
3. The Potential Risks of a Personal Loan
If you take a credit card debt, you can pay it off over an undetermined period of time. If you take a personal loan, you must pay it back within a predetermined period. Although you will be paying off the debt faster, it can become a problem if you will not be able to finish paying within the allotted time. Since your loan has no property that acts as its security, in case of default, the lender might resort to hauling you to court to recover their money.
On the other hand, if you pay off your loan too early, you may also end up paying some extra fees. Some fine prints in the loan agreement pertain to prepayment penalties if you pay off your loan before a certain date.
Be extra careful about scammers who take advantage of people looking to get a loan. Some will make you sign an ‘advanced fee’ loan, which is actually a fake loan agreement. It will require you to pay an advance fee for a loan you will never receive. Once you give them the money, it’s gone – together with whatever personal information you may have given to the scammers.
4. Your Credit Score Determines Your Affordability
Whether the lender will decide to grant you a loan and at what rates, depend somehow, on your credit score. If you have an average to above-average credit score, you may be more likely to get an approval and even possibly an interest rate on the lower bracket of the lender’s chart. The point is, go through the application process knowing your true credit score.
There are actually several ways to get your credit score for free. It is mandatory for credit reporting companies like Transunion and Equifax to provide one report at no cost to you every year. Banks and personal loan lenders also offer free reports to their applicants.
As soon as you get hold of a copy of your credit score report, read through it carefully item by item. The report could have erroneous entries such as incorrect personal information or worse, a fully-paid bill or loan that is still carried as outstanding. Should you discover a mistake, file a dispute with the credit bureau and aim that they correct the entry immediately. You can improve your credit score by cleaning up any inaccuracies on your record.
A credit report can also show you some actual outstanding payments. Maybe you have an old credit card bill that you have forgotten to settle. You can and you should address it before you apply for a loan.
5. Compare The Cost, Consider The Fees
Your loan will have an annual percentage rate or APR (e.g. 15% APR) – this is the standard way of comparing the cost of a loan for each year. However, any numerically-savvy lender can manipulate the APR so the best way to realistically compare a loan is to look at the total amount repayable. This is the total cost (including interest and charges) that a borrower has to pay from the first payment to the last installment. Of course, the first rule is to make sure that the monthly payment is within your budget – you can simulate it with our APR calculator.
When it comes to loan payment, it is the total cost, that is most important. However, it would be good to know if the total amount repayable already includes charges aside from interest, such as an origination fee. When you are comparing loans, make sure you include the origination fees (and all other fees) that all the lenders you are considering will pass on to their borrowers.
6. Be Aware of Penalty Charges
In practically all types of loan, there is a penalty if you fail to make your regular payment. This penalty becomes part of your loan account and you would have to pay it. So make sure that you know the exact details of the penalties you may incur in case of circumstances that can arise in the future.
Affordability of the loan is key so make sure you can pay it before you even consider filling out a loan application form.
7. You Are Likely to Find The Best Loan Deals Online
The online lending marketplace has risen to prominence in the recent past. Online lenders do not have too big of an overhead cost so they can grant loans with lesser fees and lower rates.
A lower interest rate means less expense for you and more money in your wallet in the long run. Lending Club, for example, claims that their rates are 33% lower on average for customers who consolidated their debt or paid off their credit cards using their personal loan.
8. Check The Fine Prints First
There are as many kinds of loans as there are as many lenders; some companies appear more stable and trustworthy than others. So it is indispensable that you have a good idea of the company you’re dealing with before you apply for a loan.
How long have they been in operation? Do you have access to customer reviews on their website? Do they have a good reputation in the business circle? In case you are drawing a blank, you can contact the Better Business Bureau to see if the outfit is legit or if there have been any complaints against them.
Another item to scrutinize in the fine print is additional fees. Make sure that the lender isn’t going to slap you with a penalty if you pay off early. Some companies make it a practice to charge pre-payment penalties but there are those who don’t. The lender could also charge an origination fee or the cost of administering the loan. To be certain, visit the lender’s website and look into what you may have to pay. The good news is, it is possible to find a company that doesn’t charge either of these fees.
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In this chart using Experian data, you can see the highest average personal loan balance is in Washington state. However, the highest average states are separated by only a couple of hundred dollars. The exception to this is Montana, which is over $3,000 lower for average personal loan balances.
How Much Income Do I Need for a Personal Loan?
A personal loan can allow you to borrow between $5,000 and $100,000 depending on your financial situation. However, each lender has its own eligibility criteria.
To determine how much they will lend you and what rate of interest you will get, lenders typically consider the following criteria.
1. Credit score
Credit scores are a number between 300-850 those lenders use to evaluate your loan application. Higher scores are better. Good to excellent credit scores, which are between 670 to 850, indicate that you are a low-risk borrower. Therefore, lenders will be more inclined to approve you for a loan with favorable terms.
You may still be eligible for a loan even if your credit score is not great. You may have to cosign or pay higher interest rates in order for your loan application to be approved.
To ensure that borrowers have sufficient income to repay new loans, lenders may impose income restrictions. Lenders have different minimum income requirements. Prosper, for example, has a minimum annual gross income of $85,000; Best Egg's minimum annual income requirement is only $100,000. However, don't be surprised if your lender doesn’t disclose minimum income requirements. Many lenders don't.
Recent tax returns, bank statements, pay slips, and signed letters from employers may be evidence of income. Self-employed applicants can also provide bank deposits or tax returns.
3. Ratio of debt-to-income
Lenders will consider your income and credit score in order to determine how much loan you can afford. The DTI ratio refers to the monthly amount of debt you have compared to your monthly income.
If you have a $1,000 mortgage and earn $5,000 per month, your DTI ratio would be 20%. This is the sum of your debt ($1,000) divided by your income ($5,000).
The DTI should be as low as possible. This will show lenders that you are able to afford the monthly payments for the loan you apply for. Your ratio will likely be too high and you won't be eligible for a loan. You may have to accept a lower amount than you really want to borrow.
Don't worry if your credit isn't great or you don't have enough income. You may still qualify for loans up to $100,000 if you have cosigners. Cosigners are people with stable income and good credit who apply for the loan along with you. They will make the payments if you are late.
A cosigner lowers the risk for your lender, which makes them more likely to lend you the amount you request. A cosigner is a great way of getting a lower interest rate.
Your lender may require that you pledge valuable assets or collateral if you apply for a secured personal loan. For loans for vehicles or homes, the collateral will usually be related to the loan's underlying purpose.
Secured personal loans can be secured by cash, investments accounts, and collectibles such as coins or precious metals.