Whether you’re looking to make a large purchase, or need extra money to help you overcome a financial hiccup, a personal loan can be a powerful and helpful tool. However, these loans aren’t as straight forward as they may seem. There is a lot of nuance and details that go into personal loans.
What is a Personal Loan?
A personal loan is a type of loan that helps you meet your current financial needs. Unlike a traditional car loan or mortgage, a personal loan can be used to help you pay for a wide selection of goods or services. A personal loan’s flexibility is certainly its most attractive benefit.
One may consider a personal loan to help them pay for an unexpected life expense, a major house repair, a wedding, family vacation or even as a tool to help them consolidate and streamline their debt. Most local brick and mortar banks and credit unions offer personal loans. However, you may also find online lenders offering a variety of personal loan programs.
Like any loan, the lender is offering you their money but expects the full amount, plus interest, to be repaid over a specific period of time. It’s most common for a lender to require the borrower to pay back the entire loan in recurring monthly installments for a specific number of years.
How Can a Personal Loan be Used?
Personal loans can be used for any of your financial needs. However, using personal loans for some needs can be more beneficial than others. Some of the common examples include:
Debt consolidation refers to the process of combining multiple debt obligations into a single new loan. This provides the opportunity to keep your debt organized into a singular monthly payment, instead of trying to remember what day of the month your other debt obligations need to be paid.
Additionally, the interest rates on a personal loan may be less than the interest rate on your other debt obligations. For instance, your credit card debt may have a 20% interest rate, whereas a personal loan may have a 6% interest rate. Simply consolidating your credit card debt into a personal loan can save you 14% on the interest expense!
Emergencies are not only unpredictable, they can be expensive. Your car may need a new engine, or your furnace may need to be replaced in the middle of winter. If you don’t have a proper emergency fund, it will be difficult to cover various emergency expenses.
If you find yourself in a pinch, a personal loan can alleviate that pressure and provide peace of mind. Instead of covering the full expense of a new engine or furnace, a personal loan will allow you to finance this expense over a few years.
Some of life’s most precious moments are also the most expensive. Weddings are a great example. Without much effort, a wedding can easily cost a couple over $25,000! It’s not only difficult to save up that much money, it’s even harder to part with it if you happen to have it saved. More and more people are looking for personal loans as an option to help them finance life events.
There are pros and cons to borrowing money against your home via a line of credit. For those who are against using their home as collateral, a personal loan may help you build a new deck, replace the roof, or remodel the bathroom. You leave your house out of the equation and keep your payments completely separate.
How to Apply for a Personal Loan
Applying for a personal loan isn’t a difficult process. You can do it through your local brick and mortar bank, credit union, or even various online lenders. Each lender will offer a different personal loan package. Some lenders offer lower interest rates and extended loan periods. Other lenders may have higher interest rates and a shorter repayment time frame. Be sure to shop around to find the most competitive loan possible.
Each lender will require support documentation and will have their own set of eligibility criteria. Generally speaking, two forms of identification must be presented and submitted, and the borrower must be at least 18 or 21 years old. Beyond that, a bank will do their financial diligence to confirm you are able to, and likely will, pay back the money they lend you.
What Banks Look For
There are a series of statistics, scores, and data a lender will review before approving or denying your loan request. These variables include:
A credit score is an essential component for banks to determine your repayment capacity. Credit score usually ranges from 300 to 850. Anything above 670 is generally considered a good score in the eyes of a lender.
If you don’t have good credit, that’s okay. Some lenders will issue you a personal loan, but it may come with more stipulations or a higher interest rate. A credit score is calculated on five major factors:
1. Payment History
Paying your bills on time (less than 30 days) improves your credit score. Lenders want to see a history of consistent, on time, bill payments.
2. Credit Utilization Ratio
This is a ratio that calculates how much credit you’re using and comparing it to the total amount of revolving credit you could use. For example, if you have a total credit limit of $50,000, and you have $10,000 in credit debt, your credit utilization ratio is 20%. The lower the ratio, the better.
3. Length of Credit History
Lenders are generally risk averse. They want to be sure every time they lend money, that money will be returned to them. For that reason, your credit history is important. Your credit history shows a lender how long you’ve used credit for, and what your repayment history has been. With this data, a lender will determine if they are comfortable giving you their money or not.
4. Credit Mix
Your credit mix is the different blend of debt or credit you’re using. If your only debt or in existence is a car loan, your credit isn’t mixed. However, if you have numerous bills and debt obligations, your debt is mixed across a variety of sources. Your ability to pay a variety of sources, on time, is what credit agencies like to see.
5. New Credit
New credit is an important variable. Whereas lenders like to see your credit history, they also want to see your most recent behavior. If you’ve recently had your credit pulled for a variety of reasons from numerous sources, this may be alarming in the eyes of a lender. The lender may get suspicious as to why so much credit was recently issued to you.
The most popular credit score used by lenders is FICO, created by The Fair Isaac Corporation and its score ranges from 300 to 850.
Proof of Income
Your local bank, credit union, or even the online lenders, will require you to provide proof of income. Lenders want to be sure you have the ability to pay back the money they are giving you. There are a few ways to provide proof of income, including:
Pay stubs (also known as a paycheck) are provided by employers to their employees. This pay stub can be utilized as proof of income because it includes all the information about how much money you made in a specific period. The lender will likely ask for your most recent pay stubs (the trailing 2-4 weeks).
Letter From Employer
Some lenders might ask for a letter from your employer to ensure that you work for that company. Alternatively, sometimes the lender will just contact your HR department and ask if you are currently employed in the company you claim to be employed through.
Proof of Income from Tax Documents
W-2 form – A W-2 is an important tax document that can be used as proof of your income because it informs your lenders about income in a given year. In addition to providing recent pay stubs, many lenders will ask for your most recent year or two of tax returns. This highlights how long you’ve been employed, and how ‘secured’ the bank may feel like your position or employment eligibility is.
Independent contractors, or folks who are self employed, will provide a 1099 instead of a W-2.
Tax return: Your trailing year or two of your tax return and paperwork may also be a requirement. Again, this shows the history of your income and can be important if you are not actively working. Money from a pension fund, social security, or annuities will all be present on your tax return.
Debt to Income Ratio
Your Debt to income ratio is a financial ratio that measures your monthly debt against your gross income. This is one of the most common ways lenders measure your ability to repay the loan you’re applying for.
To calculate your debt to income ratio (DTI), you simply need to add your monthly debt payments and divide the amount by your gross income (or the income you earned before tax and other deductions).
For example, if you pay $1,000 a month in debt (car loan, credit card debt, and student debt) and your monthly gross income is $5,000, your monthly debt to income ratio would be 20%.
The lower your DTI, the more capable you are of paying off the debt you are applying for. If the number is too high, which may vary from lender to lender, you may not qualify for any additional credit.
Your monthly income is an important part of your financial profile as it directly indicates your ability to repay the borrowed amount. Banks and other financial institutions will ask for your annual salary in various details and they can check for your minimum earnings in the list to qualify you for a loan.
Someone earning $40,000 a year may not qualify for as much of a loan as someone earning $250,000 a year. Of course, your salary isn’t taken in isolation as the individual earning $250,000 a year may exceed the lenders debt to income limit, whereas the individual earning $40,000 a year may have great credit and a very low debt to income figure.
You must be of legal age to obtain a personal loan. In the United States, this is 18 years old. Some 18 year olds do not have a full-time job, credit history, or a debt to income ratio. For that reason, a bank may require you to have a cosigner to be eligible for the loan.
Older age is also taken into consideration. Banks want to be certain you have the ability to pay off the loan. Therefore, someone who is say 95 years old may not qualify for a personal loan as the bank feels like this age is too risky to lend to.
Types of Personal Loans
Lenders offer a variety of personal loan options. Each option has its purpose, and each option will have various pros and cons worth considering. There is not a one size fits all approach, so before you apply for a loan, make sure you understand all the options out there so you can select the best option for your needs.
Unsecured Personal Loan
An unsecured personal loan is a common type of personal loan that can be easily acquired if you have a good credit score. An unsecured personal loan is a popular choice as the borrower isn’t using one of their assets (their house, car, or business) as collateral for the loan.
Due to not having to provide collateral to obtain this loan, a bank typically charges a higher annual percentage rate (APR) so they make more money as a result of exposing themselves to more risk.
Just because you don’t have to use your home as collateral doesn’t mean there is no consequence if you default on the loan either. Banks have their ways of getting money from you, and any late or defaulted payment will certainly impact your credit score.
Secured Personal Loan
A secured personal loan is backed by collateral. This means you’ll need to provide an asset, such as your home, or cart, to the lender to guarantee a portion of the loan. If you happen to default on the loan, the borrower is entitled to the asset.
One of the best things about the secured loan is that the interest rate is comparatively lower than unsecured loans because lenders find this type of personal loan less risky since they have the right to take away assets if you failed to repay the loan.
Many personal loans are a fixed rate personal loan, which means the interest rate and monthly payment remain the same for the life of the loan. A benefit of a fixed rate loan is the consistency in which you can predict your financials. If your fixed rate amount is $200 for 60 months, you can properly plan for this over the next 5 years.
Variable Rate Loan
Variable rate loans have an interest rate which will change over time. Typically, these variable rate loans start off with a low interest rate and increase. However, these interest rates are ties to the interest rates in the overall market at that time.
If you personally want to bet against a rising interest rate, this loan may be right for you. However, you need to be aware of the cons that come with this loan. Considering the interest rate is variable, so is your monthly payment. It makes it more challenging to plan your financials accordingly if you’re not entirely sure what a specific monthly payment will be.
Debt Consolidation Loans
A debt consolidation loan is a type of personal loan that combines the existing loans into a single loan and allows you to make payments every month. One would choose to use a debt consolidation loan if they have outstanding; medical debt, student loans, car debt, credit card debt, etc.
Lumping all the debt to one lender has a few benefits. First and foremost, it keeps your finances organized. Secondly, you may be able to not only consolidate your debt, but also reduce your overall interest rate on debt. This could save you a lot of money!
Personal Line of Credit
A personal line of credit is an unsecured personal loan that has a variable interest rate. Although the interest rate is variable, it tends to have a lower overall interest rate when comparing it to your traditional credit card. Instead of getting a lump sum of cash, you have access to this money as needed.
One of the main attraction pieces to a personal line of credit is, you only pay for the money you actually borrow. For example, if you receive a $20,000 personal line of credit, and only borrow $8,000, you’re only paying interest on $8,000. The balance doesn’t have an interest expense until you use it.
This is helpful if you are doing renovations to your home as it’s nearly impossible to forecast the expense 100% accurately when doing a renovation project. Instead of taking out more money than you need to and paying interest on the full expense, you can draw from this line of credit as needed.
Pros and Cons of Personal Loans
Personal loans do offer many benefits and despite their apparent attractiveness they also have some disadvantages. Here we’ll go over the pros and cons of personal loans to make it easier for you to make an informed decision.
The following are the reasons why personal loans might be a good choice.
No Collateral Required
Personal loans often don’t require any collateral. This is a great option for those borrowers who are just starting out and do not have any assets to borrow against.
Unlike other types of loans such as a mortgage or auto loan, a personal loan is incredibly flexible. Personal loans can be used to consolidate your debt, help pay for an emergency expense, replace or repair expensive appliances, renovate your home, pay off expensive medical debt, or even help pay for a major life event such as a wedding.
The only thing worse than too much debt, is having so much debt it’s difficult to keep track of. If you need help keeping your finances organized, a personal debt consolidation loan may be the right choice for you. You’ll have one monthly payment and all your debt can be rolled inside of that payment.
You Don’t Need Great Credit
Although great credit helps, it’s not an absolute requirement. Lenders will still issue you a personal loan if you have less than an ideal credit score. Various other ratios and measures go in place to provide the lender with a sense of security that you’re willing and able to pay off the money you borrow.
Despite their benefits, personal loans might not be the best option due to the following reasons.
Higher Interest Rates
Since most personal loans are unsecured and based on the borrower’s ability to repay, the interest rate is slightly higher than other types of loans that are backed by collateral. This is because the higher risk factor is involved in lenders.
Having access to money may make you more inclined to spend it. A personal loan shouldn’t be treated as a security blanket for overspending. If something is too expensive to afford, you may need to pass on purchasing it instead of obtaining more debt just to pay for it.
Personal loans provide great flexibility, but that can be a problem as it may lead to excessive spending.
Many personal loans have an origination fee, typically ranging from 1-10% of the total loan value. This can be quite costly, not only in the immediate time period, but also the opportunity cost associated with that fee over the length of the loan. The total loan cost (interest rate, origination fee, and length of loan) needs to be factored into the equation before you can decide which loan is best suited for you.
A personal loan can be obtained at your local bank, credit union, or even through various online lenders. These loans allow you to consolidate your debt, finance more expensive purchases that may be out of reach if you could only pay for them with cash, and pay for the unexpected, or major life events.
Each vendor will have their own set of criteria one must meet to qualify for these loans, and there are various loans one may consider. Your credit score, debt to income ratio, credit history, and overall income will all be taken into consideration before you get approved for a personal loan.
For every benefit of a personal loan, there is a potential drawback. Be sure to consider all financial options before making a decision one way or another.