Personal loans can provide you with the money you need for just about anything. If you need some extra money for something other than a home or a car, a personal loan may be a good option for you. Whether or not a personal loan makes sense will depend on your financial situation. To better understand how personal loans work, we’ve mapped out all of the important things you need to know and consider.
What is a Personal Loan?
A personal loan is a type of loan that can be used for many different things, including home renovations, medical expenses, weddings, or consolidating debt. With personal loans, a borrower takes out a fixed amount of money that they can use while paying back the amount of the loan via installments each month until the loan is completely paid off.
How Does a Personal Loan Work?
Once you are approved for a personal loan, the lender will transfer the money to your account. At that point, you can use the money for your needs, whether it’s to make a big purchase or to pay off high-interest debt. In some cases, you may be bound to use the money for the reasons listed when you applied for the loan with a lender.
When you receive a personal loan, you must also pay an origination fee. This fee usually runs between 1 and 6 percent of the total value of the loan. In most cases, the origination fee is bundled into the overall financing package. For example, if you borrow $5,000 via a personal loan and the lender charges a 2% origination fee, your total loan amount will be $5,100. The lender may also automatically deduct the amount of the origination fee from the loan itself. So in the example we just used, you would receive a loan for $4,900 ($5,000 minus the $100 origination fee).
Personal loans are considered unsecured loans, meaning they are not secured by an asset like a house or a car. What this means is that if you fail to make repayments, the lender does not have something material it can repossess. Instead, people that default on unsecured personal loans can be sued by the bank. If they can gain a judgment against you, they may be able to collect the money owed. As unsecured loans, personal loans are riskier than secured loans for lenders. This is why they often have higher interest rates than secured loans. Even with higher rates than secured loans, personal loans often have lower rates than credit cards.
One thing that often gets overlooked with personal loans is the impact on a person’s credit score. Missed payments can harm your credit score. However, carrying debt on a personal loan may boost your credit score. It can also reduce your credit card utilization ratio, which is a factor used to calculate your credit score. If you can consistently make on-time payments, this will build a positive credit history that can improve your credit score as well.
What Do I Use a Personal Loan For?
Personal loans can be used for many general purposes. Whether or not a personal loan is the right type of loan for you will depend on your unique financial situation and needs. Consider some of the following uses for personal loans.
- Credit card debt consolidation — Many people use personal loans to consolidate credit card debt and reduce the amount of interest they pay. By consolidating credit card debt under a personal loan, you can focus on making one, lower-interest payment each month rather than multiple, high-interest payments to various card issuers.
- Medical expenses — Some people face a mountain of medical bills due to emergencies or serious injuries or illnesses that arise. If your healthcare provider does not offer flexible repayment plans, a personal loan could be another option to help cover the expenses.
- Financing a business — Whether you’re starting a new business or need money to help grow an existing business, a personal loan could help you get the money you need to take your professional dreams to the next level.
- Personal emergencies — Life happens fast, and sometimes people have personal emergencies that can break the bank if they’re not prepared. Whether you unexpectedly lost your job, need to suddenly move, or need help paying for an emergency vet visit for Fido, a personal loan can be a good option to get funds in a pinch.
- Home renovations — While many people can get home equity line of credit (HELOC) loans for remodeling or renovating their home, there are some instances where a personal loan may be a good option, too. If a HELOC loan is not available or if you need money to handle a housing issue quickly, you may consider a personal loan.
What Are the Different Types of Personal Loans?
There are a few different types of personal loans that you may come across when researching your options. Take a look at some of those types below to understand what they mean for you.
Fixed-Rate and Variable Rate Personal Loans
Most personal loans are fixed-rate loans, so the interest rate doesn’t change during the repayment period. In some cases, you may come across a variable-rate personal loan that could be appealing. You will want to be sure to ask if there is a maximum interest rate as any adjustment that increases your rate will mean your monthly payments could increase substantially. You will also want to understand the terms under which the interest rate adjusts.
Secured and Unsecured Personal Loans
As mentioned earlier, most personal loans are unsecured loans, which means the lender looks at factors that impact your ability to repay the loan before accepting your application. In other cases where you are using a personal loan to purchase something like a boat, the lender may stipulate that the asset will be used as collateral for the loan. As a secured personal loan, that means the lender can repossess the asset if you fail to repay the loan.
If you’re considering a personal loan, be sure to thoroughly research your options, including interest rates, repayment terms, and the reputation of the lending institution. The more information you have, the easier it will be to make a decision that can improve your financial situation.