Introduction

Taking out a personal loan can be a major financial decision. With so many options and factors to consider, it’s important to understand exactly what personal loans are and how the process works before moving forward. This comprehensive guide will provide an in-depth look at personal loans, their pros and cons, how interest rates and approvals work, and alternative financing options to weigh.

What is a Personal Loan?

A personal loan is a fixed amount of money borrowed from a bank, credit union, online lender, or other financial institution. The loan amount, interest rate, fees, and repayment terms are set at the time the loan is approved.

Personal loans are considered “unsecured” loans, meaning they do not require any collateral to obtain approval. The borrower’s creditworthiness and income are the primary factors lenders use to make approval decisions.

Once approved, the borrower receives the full loan amount in a lump sum payment. They then repay the loan in fixed monthly installments over the loan term until the principal and interest are paid off. Loan terms typically range from 1 to 5 years.

Personal loans can be used for almost any purpose except financing a business. Some common uses include:

  • Debt consolidation – Combining high-interest debt into one personal loan at a lower rate
  • Major purchases – Financing appliances, furniture, medical procedures, etc.
  • Home improvements – Funding renovations and repairs
  • Special occasions – Weddings, family vacations, etc.
  • Emergency expenses – Sudden medical bills, home repairs, etc.
  • College tuition – Paying for school when financial aid is insufficient

The flexibility of personal loan funds is a major advantage over other financing options tied to specific uses, like auto and mortgage loans.

How Do Personal Loans Work?

The personal loan process from application to funding usually follows these basic steps:

Loan Application

The process begins by submitting a loan application to lenders. This can be done online, in person at a bank or credit union, or over the phone. Lenders will request personal, employment, and financial information such as:

  • Name, date of birth, address, Social Security number
  • Employment status and income
  • Housing expenses
  • Bank account details
  • Details on other debts and obligations
  • Assets and valuables

Credit Check and Underwriting

Next, the lender will conduct a hard inquiry on the applicant’s credit reports to review their credit score, history, and existing debts. Most lenders require minimum credit scores between 600 and 700.

Lenders will also verify income and employment status. They use debt-to-income ratio thresholds to determine if applicants have manageable monthly debt payments relative to income. Lower debt and higher income improves loan eligibility.

Loan Decision

Based on the applicant’s credit reports, income, and current debt obligations, the lender will decide whether to approve or deny the loan application.

Approved applicants will get loan offers showing the maximum loan amount, interest rate, fees, and repayment terms available based on their qualifications. Those denied will receive notice explaining the reasons, often due to poor credit or excessive debt burden.

Loan Closing and Funding

Once approved, the borrower will need to provide any requested documentation, sign final loan documents, and agree to the repayment terms. This may be done electronically or by paper documents.

The full loan amount is then deposited directly into the borrower’s bank account within a few days of approval. Some lenders provide same day funding.

Repayment

Borrowers are required to make monthly principal and interest payments over the loan term until the balance is paid off. Payments are typically made via automatic bank withdrawals. Late or missed payments will incur fees and negatively impact credit scores.

Paying off an installment loan early or refinancing can result in interest savings. Prepayment penalties vary by lender. Borrowers should check loan terms carefully before signing.

Loan Maturity

The loan ends once all principal and interest is repaid per the repayment schedule. The account is closed and the borrower now has one less debt obligation. Their credit reports will be updated to show the loan as “paid in full”, which can help improve credit scores over time.

Interest Rates, Fees, and Loan Amounts

The specific loan offer an applicant is approved for will depend on the lender’s rates and their underwriting criteria. Here are some key factors that determine personal loan terms:

Credit Score – Borrowers with excellent credit (scores above 720) qualify for the lowest interest rates from most lenders, often starting under 10%. Lower credit scores can pay rates of 15-35% or higher.

Income – Higher and more stable incomes demonstrate better repayment ability. Strong income can help offset weaker credit scores during underwriting.

Debts – The total amount of existing debt payments relative to income (DTI) greatly impacts approval odds and interest rates. The lower the DTI, the better.

Loan Term – Loans paid off quicker in 1-3 years have lower interest rates than longer 5 year terms. The tradeoff is higher monthly payments.

Origination Fees – Upfront fees of 0-6% of the loan amount are common. The fees get deducted from the loan balance prior to funding.

Lenders Compared – Online lenders often offer the lowest rates but charge origination fees. Banks approve based on existing relationships.

Shopping and comparing loan offers from multiple lenders can help borrowers find the optimal combination of rate, fees, and loan amount for their situation.

Pros and Cons of Personal Loans

Personal loans provide quick access to financing but also come with costs and risks to weigh.

Pros

  • Fast funding. Can receive funds in days rather than weeks or months.
  • Fixed payments. Interest rate and monthly payments don’t fluctuate over loan term.
  • Predictable payoff. Clear payment schedule with set end date.
  • Unsecured funding. No need for collateral like a home or car title.
  • Can improve credit. Making on-time payments builds positive credit history.
  • Consolidate debts. Can combine other debts into one monthly payment.

Cons

  • Credit checks. Too many hard inquiries when shopping rates can ding credit scores temporarily.
  • Interest costs. Personal loans charge higher interest rates than secured debt like mortgages.
  • Missed payment fees. Late payments incur penalties and credit score damage.
  • Predatory lenders. Some lenders have overly high rates for those with poor credit.
  • Debt temptation. Easy access to funds can lead borrowers to overspend.
  • Difficulty paying off early. Prepayment penalties may apply with some lenders.

Consumers need to weigh the convenience and flexibility of personal loans against their short and long term costs based on personal financial situations.

Alternatives to Consider

Personal loans aren’t the only financing option. Depending on individual needs and circumstances, some alternatives to consider include:

Credit Cards – Good for smaller recurring expenses with incentives like rewards points and sign-up bonuses. Try to pay off in full each month to avoid high revolving interest charges.

Home Equity Loan – Secured financing using home equity. Has tax deductible interest but only applicable for homeowners with sufficient equity.

Auto Loan – For financing vehicle purchases. Has lower rates than personal loans if collateralizing the car.

401(k) Loan – Borrows against retirement savings. No credit check needed but risks losing earning potential. Should be used sparingly.

Peer-to-Peer (P2P) Lending – Connects individual borrowers and investors directly. Offers competitive rates but minimum credit scores are high.

Payday Loans – Provides immediate cash against future paychecks but has excessively high interest rates. Should only be used as an absolute last resort.

Family Loans – Borrowing from relatives avoids credit checks and offers low rates. But can damage relationships if not paid back as agreed.

Thoroughly researching all available financing options including personal loans allows consumers to make the most prudent choice for their situation.

Key Takeaways

  • Personal loans provide fixed-rate unsecured financing for any purpose except business use. No collateral is required.
  • Favorable credit history, income, and low debt burden are key prerequisites for the best loan approval terms.
  • Interest rates, fees, loan amounts, and eligibility differ significantly between lenders. Comparison shopping is highly recommended.
  • While fast and flexible, personal loans have higher rates than secured debt like mortgages or auto loans. Interest costs accrue rapidly if payments are late.
  • Those able to qualify for low rates can benefit from consolidating credit card balances into a personal loan to save on interest.
  • Weigh personal loan benefits and costs against alternative financing options like home equity loans, credit cards, 401(k) loans, etc. Choose based on individual financial circumstances.

Frequently Asked Questions (FAQ)

How much can I borrow with a personal loan?

Loan amounts range from $1,000 up to $100,000 depending on income, credit history, and existing debt obligations. Those with excellent credit scores and low debt can qualify for up to 40%What credit score is needed to get approved for the best personal loan rates?

For the lowest interest rates from most lenders, a credit score above 720 is recommended. Scores between 670-719 will qualify for reasonable rates. Anything below 620 will mean high rates or denial.

Where can I get a personal loan besides a bank?

Online lenders like LendingClub, Prosper, BestEgg, and SoFi offer competitive rates. Credit unions are another option. You can also borrow from 401k plans, home equity, life insurance cash value, etc.

Should I take out a personal loan to pay off credit card debt?

If your credit card interest rates are higher than a personal loan rate you qualify for, consolidating balances into the lower-rate personal loan saves money on interest and simplifies repayment with fixed monthly payments.

Can a personal loan improve my credit score?

Making on-time principal and interest payments shows lenders you can responsibly manage installment loan accounts. This builds your credit history and can gradually improve scores over the loan term.

Where is the best place to compare personal loan rates and offers?

Comparison sites like LendingTree, Credit Karma, and NerdWallet allow you to check personalized loan offers after a soft credit check. This preserves your score while shopping rates.

Samuel Mitchell