How Do Personal Loans Work?

A personal loan application is an excellent financing option for those who need to quickly access a lump sum of cash.

Personal loans offer fast and flexible financing without limitations on its use.  However, fees and interest rates are quite expensive.

Is a personal loan right for you? 

Will it impact your credit score?

We’ll answer these questions, so keep reading!

What Is a Personal Loan?

A personal loan is borrowing fixed monthly loan amounts and rates from a lender. 

You submit a loan application and qualify based on your credit history and annual income. In addition, personal loans give you the security of knowing the loan rates.

You can use a personal loan for a variety of purposes:

• Education expenses
• Medical expenses
• Major household purchases
• Consolidate debts

 

Loan Terms

You probably have a few questions about this if you’re new to borrowing money.  There are important details to know about personal loans.

Common terms include:

Principal

The money you borrow is called the principal amount. The lender calculates the interest they’ll charge you based on the principal you owe.

The principal amount decreases as you continue to make payments on your loan.

Interest

The interest is the lender’s “charge” for letting you borrow money and repay it over time.  Taking out a loan means you’ve agreed to a payment rate “with interest”(expressed as percentage rates).

The portion of your payment and rates goes toward reducing the principal.

Annual Percentage Rate (APR)

You must be aware of the APR you are paying.  The APR (Annual Percentage Rate) is the rate charged to you by the lender when you apply.

It includes the interest rate and any lender fees to give you a good picture of the total cost.

Comparing APR is a good way to compare the affordability and value of different loans.  Financial institutions must disclose the APR rate before any agreement gets signed.

Comparing APR rates is difficult because lenders choose the charges included in their rate calculation.

An APR rate may not reflect the actual cost of borrowing because the fees might be either included or excluded.  Stay away from a high APR because the cost could end up overwhelming your budget.

Term

This is the life of the loan or repayment terms.  The term is the number of months you have to pay it back.  The time it takes to eliminate the debt is a loan’s term.  Loans can be short-term or long-term.

They include interest rate and repayment terms upon approval of your personal loan.

A loan’s term affects your monthly payment and your total interest costs.  The longer the term, the smaller the monthly payments. 

The longer you owe money to your lender, the more you pay in interest rates.

Monthly Payment

These are the loan amounts you pay monthly to the lender during the term. It includes repayment terms for a portion of the principal plus the interest rates.

No surprises here because you pay the same loan amounts every month.  This is good for debt consolidation.

Receiving the Money

You receive all the money you’re borrowing right away when you get a personal loan. It is deposited straight into your bank account. 

Collateral

This refers to a valuable item used to secure a loan. Examples include your car, house, or other possessions.

Personal loans DON’T REQUIRE collateral. They can’t take your possessions in case you can’t pay your loan. However, if you miss a payment, it will affect your credit score.

Questions to Ask Before Checking Personal Loan Eligibility

Let’s say, for example, you meet the best personal loan eligibility requirements. Despite this, you still might not be suited to borrow.

Ask yourself these important questions before you pull the trigger:

 

Do You Really Need a Personal Loan?

It’s tempting to think you can have cash delivered to your bank account in an instant. But the important question is… Do you REALLY need it?

Think about it.  What if you’re OVERSPENDING?

Applying for the best personal loan to help cover this reason…is never a good idea.

You DON’T really need a new flat-screen TV.  Or that last-minute African safari.

If you face a medical emergency and you don’t have an annual income, that’s another story. Tied to sky-high rates of your credit card?

That definitely deserves your immediate attention.

Can You Afford a Personal Loan?

Qualifying for the best personal loan doesn’t mean your budget can realistically cover the monthly payment and rates.

Especially if you’re currently saving up for other financial goals.

Things to look for when considering a personal loan include:

•  Prepayment fees
• Annual Percentage Fees (APR)
• Application fees
• Origination fees

Many personal loans do tack on an origination fee.  Every lender has its own set of criteria when it comes to an origination fee.  An APR is charged to you for making a loan.

Even if you think you can pay it off sooner than later, go with a lender who won’t charge a prepayment penalty

Personal loans are an excellent source of short-term financing, but you have to address your credit profile so that the new loan doesn’t end up as the beginning of a cycle.

What Is a Credit Score?

 A credit score is a number that shows credit information.  It shows a consumer’s “creditworthiness.”

The higher the score, the better the APR. This is because the better borrower’s credit profile looks to potential lenders.

Personal loan lenders look at the details and the risk involved in lending you money.

 

Why Your Credit Score Matters

Borrowers with a bad credit profile present a great risk of missing monthly payments or defaulting. This is why some loans have a minimum credit score to qualify.

A minimum required credit score may get you in the door, but higher scores tend to have better loan options and APR.

Lenders are more likely to approve you for the best personal loan if your credit score is high.  You’ll need a score of at least 550 to 580 to qualify for a personal loan.

NOTE: Your credit score and how it can impact your loan.

Bad Credit Score: Below 579

You can find personal loans for bad credit, but:

• You’ll pay a higher rate than other borrowers
• You won’t qualify for the larger loan amounts

If your credit score is below 580, you should raise your score first before taking out a new loan.

Fair Credit Score: 580 to 669

If your credit score is fair, you can expect:

• Better rates than loans for bad credit
• You won’t be able to borrow as much money as a good-credit borrower could

If you get a fair credit loan, make sure you pay it off as soon as possible. Otherwise, you’ll pay a higher interest.

Good Credit Score: 670 to 739

If you have good credit, there are a variety of lender options available for you. If you have good credit:

• You’ll be able to borrow more money easily
• You’ll have approval with a lower interest rate

Lenders offer low rates for borrowers with good credit, so you might be tempted to skip rate shopping.

However, don’t skip this part.  Even if you lower your interest rate by one percentage point, it saves you hundreds of dollars.

 

Excellent Credit Score: 740 and Above

With a credit score in this range, you shouldn’t have much trouble finding a personal loan. You’ll secure a low interest rate with most or all of the best personal loan lenders. 

Pros and Cons of a Personal Loan

There are advantages and disadvantages in choosing a personal loan over other financing options. Here are some factors to consider:

Key Benefits

Flexibility and Versatility.

Other types of loans are only used for a certain purpose, but personal loans are used for many purposes.

For example, if you apply for a car loan, the only way to use it is to purchase a vehicle.

However, a personal loan is a good alternative if you want to make a major purchase and don’t want to limit yourself to just using the money.

 

Lower Rates With Higher Borrowing Limits.

They often come with lower rates than a credit card. So if you are a consumer with an excellent credit history, you get all the benefits.

You can qualify for a higher loan amount than the limit on your credit card.

 

No Collateral Requirement.

They don’t require collateral for an unsecured loan. No need to put your car, home, or other assets up as a guarantee that you’ll repay the funds.

If you’re unable to repay the loan amount, of course, you’ll face significant financial consequences. This is based on the terms you agreed with your lender.

But you don’t have to worry about losing your car or home as a direct result.

 

Easier to Manage.

A personal loan with a single, fixed-rate monthly payment is easier to manage, especially for multiple credit card debt.

Instead of having several credit cards with different interest rates and payment due dates, you can streamline your payment and save money in the process.

Drawbacks

Personal loans are a good option for some, but it depends on the situation.  Consider the following negatives before taking out a personal loan:

Interest Rates Are Higher Than Alternatives

For borrowers with poor credit, interest rates for personal loans are not always the lowest option.  They might pay higher interest rates than with a credit card.

 

Fees and Penalties Are High

As expected, loans come with fees and penalties that drive up the cost of borrowing.  Loans come with an origination fee of 1 to 6% of the loan amount.

The fees cover loan processing or the loan application fee. It’s either subtracted from the loan amounts disbursed to the borrower or rolled into the loan amount.

Some lenders charge prepayment penalties if you pay the balance off before the end of your loan term. Make sure to review all fees and penalties of any personal loans before you apply.

 

Higher Payment Than Credit Cards

A credit card will not give you deadlines for paying your balance off in full., but they also come with minimum monthly payments.

Unlike personal loans, these require a higher fixed monthly payment. Plus, it has to be paid off by the end of the loan term.

If you choose to consolidate credit cards, you need to adjust to higher APR rates and loan payoff timelines.  Otherwise, you risk defaulting.

Increased Debt

Taking a debt consolidation loan won’t address the cause of your debt.  Fortunately, debt consolidation loans free up your available credit limit. 

Owning a credit card is an opportunity to rack up more charges, especially if you tend to overspend.

Factors That Impact Interest Rate

Here are a few criteria that determine your interest rate:

Your Credit Score

A good credit score makes it easy to qualify at a lower fixed interest rate.  They review the details of your score and your credit history for adverse marks. They check if you have delinquent and defaulted accounts.

 

Debt to Income Ratio (DTI)

The debt to income ratio is your monthly debt divided by your monthly gross income.  A low DTI ratio means that you can manage monthly payments on a new personal loan.

A strong score and a low DTI ratio will attract the most competitive rates.

Where to Get a Personal Loan

Sources for personal loans are divided into main categories:  those with a banking license or charter bank and those without.

The main difference between the two involves regulation.

 

Banks and Credit Unions

The first places many people think of when contemplating a personal loan are local banks and credit unions.

These institutions are governed by:

• The Federal Reserve
• Federal Deposit Insurance Corporation (FDIC)
• Office of the Comptroller of the Currency (OCC)
• National Credit Union Administration (NCUA)

Banks and credit unions give you a personalized experience compared to other options.  You will need to meet face to face with a loan officer.

The loan officer will guide you through the details of the application process smoothly.

Take note that banks tend to have higher loan qualification standards.  And higher APR rates.

However, if you are a long-time customer, they are more accommodating and may give you favor in that area.

Credit union qualifications are less rigid than banks. And the interest rates are typically lower than that of banks.  But you have to be a credit union member to do business there. 

Banks and credit unions don’t charge loan origination rates, so that’s GOOD NEWS.

Non-Banking Financial Institutions (NBFIs)

Non-banking Financial Institutions (NBFIs) or Non-banking Financial Companies (NBFCs) source without a banking license.  The main difference is that NBFIs cannot accept deposits.

NBFIs include:

• Online and brick-and-mortar finance companies
• Insurance companies
• Peer-to-peer (P2P) 
• Payday lenders
• Other non-bank entities

When banks don’t approve a citizen for a loan, these companies will give you approval. In exchange for higher interest rates than banks and credit unions.

Payday loans are notoriously known as “predatory loans” for people with bad credit history. They offer loans with high interest rates, high APR rates, and hidden fees.

They get people who are already living from paycheck to paycheck.

How Do I Know if I Qualify for a Loan?

This is what they consider to determine if you qualify for the maximum loan amount you’re requesting:

•  Loan purpose: What you’re going to use the loan amount for. This will impact your loan contract and interest rate.
• Credit score and credit history:  This carries a lot of weight, but keep in mind that it’s not the only deciding factor.  The lender will approve the maximum loan amount if you have a good credit score.
• Debt to income ratio (DTI): Lenders look at this to see if you have a significant debt compared to your monthly income. If you’re a liability, they will lend you a small loan amount.

 

• Improve your credit: A higher credit score translates to better APR rates.
• Lower your DTI: To increase your credit score, pay down your existing debts. So they can give a larger loan amount.
• Have a secure source of annual income: Wait until you have established employment. If you have a job with a distinguished employer, it shows lenders you’re able to pay for your loan.
• Look into getting a secured loan: If you have collateral, lenders have less risk should you default.

How to Get a Personal Loan

If you’ve finally made that decision to get financing, you can start with these steps.

1.  Running the Numbers

The last thing you want to do is get a loan and realize you won’t be able to pay it off.

 How much you can borrow depends on the following:

• Credit score
• Annual Income
• Current debts

Keep in mind that lenders charge a payment fee which they deduct from your loan amount—factor in any origination fee and APR.

They usually include an origination fee and APR that are deducted from your proceeds.

Interest and APR are straightforward concepts in theory. However, knowing what APR to expect when you apply for a mortgage or a new credit card is a different story.

As for the origination fee, sometimes it’s negotiable. But avoiding or reducing an origination fee means paying a higher interest over the life of the loan.

Make sure to figure out how much cash you need after fees and what monthly payments you can afford.

Play around with the numbers to know what the loan amount will cost you and then decide if your budget can handle it.

2. Check Your Credit Score and Credit Report

Your credit score reigns supreme in the land of personal loan requirements. Reviewing it once per year is a good habit.

There are many ways to check your details online for free in a matter of minutes, and it won’t impact your score.  You’ll be able to see debts and accounts.

Keep this in mind as you review your credit report:

• Payment history
• Length of credit history
• Credit mix
• Money owed
•  New credit

Applicants with higher credit scores and lower debt-to-income ratios qualify for lower interest, finance charges, and APR.

If you have a lower-than-average score, pay off 30% until your score improves. Doing so will help you qualify for a loan.

3. Get Prequalified

Once you’ve eliminated loans for which you are ineligible, turn to lenders most likely to give you a loan.

Lenders pre-qualify or pre-approve you with a soft inquiry.  They will notify you within seconds, sometimes a couple of days later, if you have or have not prequalified for a loan.

Getting pre-qualified means filling out a short form online in which you provide the following:

• Basic information (Your name, address, and the amount to borrow)
• The lender does income verification and looks into your financial history
• The lender tells you what types of loans you’d likely qualify for, including amounts, interest rates, monthly payments, fees, and similar details.
• Compare information from different lenders and pick the one that’s best for you.

4. Choose Your Loan Type

Now that you know where your credit stands and you’ve considered your options, choose your loan type.

Which among the following types of loans is best for your situation:

 

Debt Consolidation Loans

This is the most common loan.  Debt consolidation loans mean you take out one loan amount to cover your existing debt.

As a result, you DECREASE the number of payment options you have to worry about each month and receive a lower interest rate.

Credit Card Refinancing Loans

Companies specialize in loans for people looking to pay off their credit card debt.  Personal loan rates are LOWER than credit card rates, so it’s a good way to clear your credit card balances.

You also pay them off over a longer period.

Home Improvement Loans

If you’re looking to pay for home improvements upfront without taking out a secured home equity loan, a home improvement loan is the best option for you.

Coronavirus Hardship Loans

These provide you with just a few weeks’ or months’ worth of funding. So you can pay your bills, heating, housing, and food.

They’re for people who are undergoing financial hardship due to the pandemic. You need to prove this by showing a layoff notice or a bank statement showing a drained bank account.

Medical Loans

Medical expenses are unpredictable. A personal loan is a good way to decrease the immediate financial burden.

Student Loans

If you don’t have the money for college, you can apply for a student loan. You can pay it back at a later date with interest.

You can also reduce the amount you pay in interest by making extra loan payments to pay it off sooner.

Emergency Loans

These are very useful for several purposes. A burst pipe, a car breakdown, and a smaller medical expense are good reasons for this.

5.  Consider Your Options

 If your credit score is good, you won’t have any problems. But if you have a bad credit score, you’ll really have to weigh your options.

Traditional banks can give you a hard time getting approved with bad credit. On the other hand, credit unions have short-term loans that serve as cheap alternatives to payday loans.

Some online lenders specialize in working with bad-credit borrowers.

Secured loans require collateral or a co-signer. However, having a co-signer is not a good idea because it has a big impact on your relationship. 

A vehicle, your savings account, or your home can be collateral. If you fail to pay, you’ll lose everything.

6. Shop Around for the Best Loan Rates

Don’t settle for the first offer you receive. Compare different lenders so you can get an idea of what you are qualified for. Compare the offers, rates, and fees carefully.

Limit your inquiries within a 45-day period per lender. This will count your inquiry as a single inquiry for credit-scoring purposes.

Don’t keep inquiring about different lenders for a short period of time. It will result in a hard inquiry and impact directly on your credit score.

7. Prepare Documentation

Your documentation requirements depend on the lender and your situation.  The faster you provide the details, the sooner you’ll get a decision.

Resources You’ll Need:

• Personal identification (e.g., passport, driver’s license, and Social Security card)
• Proof of residence (e.g., a lease agreement or a utility bill with your name and address)
• Proof of annual income (e.g., Current pay stubs from your employer, W-2s, or filed tax returns)
• Employer’s information (e.g., company name, manager’s name, email, and phone number)

8. Prequalify Your Lender

Go through all of the disclosures and details in your pre-approval letter. Visit their website and look for the following:

• Expected Loan Amount
• Annual Percentage Rate (APR)
• Monthly Payment
• Loan Term
• Fees and Penalties (Origination fees, Late Fees and other charges)
• Type of Interest (Fixed or Variable)
• Secured or Unsecured loan (What is the required collateral for a secured loan)
• Automatic Withdrawal (mandatory or optional)
• Arbitration (Mandatory, or can I take the lender to court?)
• Prepayment Penalty (When paying loans early)
• Fine Print (Always look for the fine print)

9. Pick a Lender and Apply

So you’ve done your due diligence.  You’ve checked everything out.  It’s time to pick a lender with the best offer for your needs!

You’ll probably do the entire application process online, depending on your lender. Provide all the details and documentation they need.  DON’T FORGET to include the loan amount and purpose.

They will give you a chance to review the terms and conditions, including all the fees and repayment schedule.

Avoid hidden fees by carefully reading the fine print.

10. Finalize and Start a Payment Schedule

CONGRATULATIONS!  For this FINAL STEP, the lender notifies you of your approval. You will now finalize all the documents and accept the terms.

Loan funds usually get released after a week. But some lenders get it to you within one or two business days.

Take note of when your first payment is due and create a schedule for all your payments.

Conclusion

Personal loans can help you, or they can bury you in debt. Make sure to borrow only what you need.

Make a plan for how you’ll use the funds and how you’ll make payments (with interest).  Remember, you will have to pay everything back eventually.

Don’t overspend if you don’t have the means to pay for it.  Discipline is the key when it comes to financial behavior.