what are personal loans

What are personal loans and how do they work?

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Need to renovate your home, pay for a medical procedure, or consolidate credit card debt? Then you might be in the market for personal loans, which are consumer loans mainly given out by banks, credit unions and online lenders. Most of these loans are unsecured, meaning you don’t need collateral, and they have fixed interest rates. Personal loans are generally paid back in installments with terms between 12 to 60 months.

Whether you qualify for a personal loan is based on factors such as your credit score, credit history and income. Getting a lower interest rate will be heavily dependent on your credit score. If you don’t have good credit, personal loans can be expensive.

Related article: How can I get a personal loan if my credit is bad?

Types of personal loans

Most personal loans are unsecured, meaning they don’t require collateral like a house or a savings account. Because of that, lenders generally charge a higher interest rate than they would for a secured loan. Secured personal loans do exist, just remember that you put that collateral at risk if you default on the loan. Of course, if you default on an unsecured loan, lenders can still come after you to repay your debt.

Related article: The pros & cons of secured and unsecured personal loans

“Just because a debt is unsecured doesn’t mean defaulting has no consequences,” says Charles Phelan, the founder of debt settlement company, ZipDebt. “You’re open to being sued and having a judgment brought against you.” 

While most personal loans have a fixed rate (meaning the interest rate doesn’t change during the loan term), others are variable. Fixed rate loans are a safer bet because you’ll know exactly how much money you need to pay each month.

Some specific types of personal loans include debt consolidation loans, where you roll up several debts into one new loan, and personal lines of credit. With the latter, you only pay interest on how much money you “pull” from the line of credit, versus paying interest on the entire lump sum loan.

Applying for personal loans

Depending on the lender, you can apply for a personal loan in person or online. Before you choose a lender, it’s a good idea to compare rates and terms from multiple lenders to make sure you’re getting the best deal.

The lender will check your credit report and will want to see proof of your income such as recent pay stubs and tax returns. Lenders also will consider your debt-to-income ratio, which is how much you pay toward your debt each month divided by your gross monthly income.This calculation will help lenders decide if they think you can afford to take on more debt or not.

To be approved for an unsecured personal loan, most banks will want you to have a credit score of 680 or higher, Phelan says. Online lenders tend to have looser requirements and could be willing to give you a loan with a credit score closer to 640, he adds. 

“In general, the lower the score, the less likely someone will be approved for a personal loan,” Phelan says. “The other factor to consider is that low credit scores generally come attached to much higher interest rates.”

The interest rates for unsecured personal loans vary widely from 10% to 32%, with the better interest rates going to people with good or excellent credit. How much you borrow, and how long you borrow it for, will also impact your interest rate and the size of your monthly payments.

Make sure you know the APR of the loan, not just the interest rate. The APR includes all the fees you’ll have to pay toward the loan. Personal loans typically have an origination fee, which is anywhere from 1% to 8% of the total amount you borrow. In most cases, the fee is subtracted from the amount you’re borrowing. Another cost to consider is whether the loan has a prepayment penalty for paying off the loan early.

When a personal loan makes sense

Like any other loan, a personal loan is debt. Which means you should think carefully before you take one on. If you want the loan for a nonessential expense like a vacation, you would be better off saving up the money so you’re not paying interest on it. 

However, if you have good credit, personal loans can be a good way to pay for needed major expenses or to consolidate credit card debt, but you’ll need to be able to get a loan with a good interest rate. Which very likely means you have the credit score to back it up.

Related article: Should I use a personal loan to pay off my credit card debt?

How Resolve can help

If you’re dealing with debt and not sure what to do, create a free account with Resolve to see what your options are. Or, you can speak with one of our experts for free.

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