What if you could apply for a personal loan with a few clicks of a mouse? What if the funds were in your bank account in a few business days? Better still, what if the rate was much lower than your maxed out credit card? Our complete guide to personal loans will show you how.
Whether you’re looking to make a purchase, consolidate credit card debt, or money to help you overcome a financial hiccup, personal loans can be a powerful tool. Here is our complete guide to personal loans.
Table of Contents
What is a Personal Loan?
A personal loan is an unsecuritized loan that can be used for anything. Unlike a traditional car loan or mortgage, a personal loan is not backed by a physical asset. It’s backed by the borrower's future earning power and history of meeting financial obligations. If you have a job and a decent credit score, you could qualify for a personal loan.
While personal loans are unsecuritized, the lender 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 fixed, recurring monthly installments for a specific number of years.
How Can a Personal Loan be Used?
The flexibility of personal loans are a major benefit. They can pretty much be used for any financial need. Here are some common uses:
Debt consolidation combines multiple debt obligations into a single new loan. This provides the opportunity to keep your debt organized into one fixed monthly payment. If you had six different credit cards, that’s six different payment due dates, which can be a hassle to keep track of.
The right personal loan could simplify your repayment process, resulting in lower interest paid, and a quicker payoff.
Additionally, the interest rate on a personal loan is often less than the interest rate on your other debt obligations. For example, credit cards often carry high interest rates upwards of 18%+. A borrower with good credit might qualify for a personal loan with a 6% interest rate.
Consolidating your credit card debt into a personal loan could save hundreds or thousand in 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 could be difficult to cover unexpected expenses.
If you find yourself in a pinch, a personal loan could alleviate financial pressure and provide peace of mind. Instead of covering the full expense of a new engine or furnace today, a personal loan will allow you to finance this expense over a few years.
Are you getting married? Need to pay for a honeymoon? Life events should be celebrated, but they aren’t cheap. A wedding can easily cost a couple over $25,000. While we don’t advocate taking on debt to tie the knot, access to a low interest loan offers payment flexibility and quick access to cash.
There are pros and cons to borrowing money against your home via a line of credit, or HELOC. 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.
In general, the underwriting process for a personal loan (making sure you can repay the loan) is faster than a traditional home equity line of credit (HELOC).
How to Apply for Personal Loans?
Applying for a personal loan isn’t a difficult process. You can do it through your local brick and mortar bank, credit union, or various online lenders. Each lender will offer a unique personal loan package. For example, some lenders offer lower interest rates and extended loan periods. Other lenders may have higher interest rates, shorter repayment time frames, and origination fees.
Be sure to check the terms across several financial institutions to make sure you’re getting the best deal.
Every lender will require support documentation and have their own set of eligibility criteria. It’s common for lenders to collect two forms of identification, past tax returns, proof of employment, and credit history.
The lender wants to know if you have the capacity and trustworthiness to pay back the money lent to you.
What Do Lenders Look For?
There are a series of statistics, scores, and data a lender will review before approving or denying your loan request.
A credit score is an essential component for banks to determine your repayment capacity. Banks want to know your track record of meeting past financial obligations. Credit score usually ranges from 300 to 850. Anything above 670 is generally considered a credit worthy score.
Some lenders will issue you a personal loan, but it may come with 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 payments.
2. Credit Utilization Ratio
This is a ratio that calculates how much credit you’re using vs. how much 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 credit utilization ratio, the better.
3. Length of Credit History
Lenders are risk averse. They want to be sure every time they lend, the money will be repaid with interest. Your credit history shows a lender how long you’ve used credit for, and what your repayment history has been. Lenders have determined that past financial behavior is a good predictor of future financial behavior.
4. Credit Mix
Credit mix is the different types of debt or credit you’re using. Common types of debt include mortgage, auto, credit cards, and personal loans. If your only debt is a car loan, your credit isn’t mixed.
However, if you have several debt obligations across multiple loan types, that could boost your credit score (assuming a stellar repayment history).
5. New credit
Whereas lenders like to see your full credit history, they also want to see most recent behavior. If you’ve recently had your credit pulled from numerous sources, this might be alarming to a potential lender. The lender could get suspicious why credit was recently issued.
Proof of Income
Financial institutions will require you to provide proof of stable employment income. Lenders want to be sure you have the ability to pay back the money. There are a few ways to provide proof of income.
Proof of Income from Employer
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 wage information for a given pay period. The lender will likely ask for two or three most recent pay-stubs.
Letter from Employer
Some lenders might ask for a letter from your employer to ensure that you work for that company. Alternatively, the lender could contact your HR department and ask if you are currently employed at the company. This higher level of due diligence is common with mortgage lenders.
A W-2 is a tax document that captures reported employment income for a given calendar year. Many lenders will ask for your most recent year or two of tax returns. Tax documents show the consistency of employment and income earned over time.
Independent contractors, or folks who are self employed, will provide a 1099 (PDF) instead of a W-2.
Trailing one or two year tax returns can serve a similar purpose as a W-2 or 1099, but shows your entire household income. For example, if your spouse works and tax returns are filed as married jointly, the added income could help qualify for credit. Passive income sources from rental property, investments, side hustles, or contract employment would be captured in the household tax return as well.
Debt to Income Ratio
Debt to income ratio measures your monthly debt against gross income. This is one of the most common ways lenders measure your ability to repay.
To calculate your debt to income ratio (DTI), 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 and your monthly gross income is $5,000, your monthly debt to income ratio would be 20% ($1,000/$5,000).
The lower your DTI, the more capable you are of paying off the debt you are applying for. If the number is too high, the borrower may not qualify for additional credit.
Your monthly income is an important part of your financial profile as it directly indicates your ability to repay the borrowed amount. Personal loans are usually paid back in monthly installments, therefore, the lender will want to see how the new loan affects monthly cash flow.
For example, a person earning $40,000 per year might not be as credit worthy as someone earning $250,000 per year. However, your salary isn’t taken in isolation, the individual earning $250,000 per year may exceed the lender's debt to income limit, whereas the individual earning $40,000 per 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, the minimum age to qualify for a loan is 18 years old. Some 18 year olds do not have full-time employment, credit history, or a proper debt to income ratio. The lender would require a cosigner to be eligible for the loan.
Older borrowers without earned income could also have difficulty obtaining credit. Banks want to be certain you have the earning capacity to pay off the loan.
What are different Types of Personal Loans?
Lenders offer a variety of personal loan options. There is not a one size fits all approach, so before applying for a loan, make sure you understand all the options.
Unsecured Personal Loan
An unsecured personal loan is a common type of loan that can be easily acquired if you have a high credit score. Which is why it is important to monitor your credit score and fix any errors. An unsecured personal loan is a popular choice as the borrower isn’t using one of their assets ( house, car, or business) as collateral for the loan.
Due to not having to provide collateral to obtain this loan, a lender typically charges a higher annual percentage rate (APR) for unsecured loans.
While unsecured loans are not “secured” by asset, the lender still has recourse if you fail to pay the loan back. Failure to pay could result in being sent to collections, garnished wages, and a drop in credit score which could affect future credit availability.
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 car, to the lender to guarantee 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. The lender has the legal right to seize the asset if you failed to repay the loan.
Fixed Rate 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 budget over the next 5 years.
Although the payment is fixed, personal loans offer the flexibility of prepayment without penalty. If you make more money or get an influx of cash, a borrower could pay off the loan or pay extra each month to save on interest over the life of the loan.
Variable Rate Loan
Variable rate loans have an interest rate which adjust over time. Typically, these variable rate loans offer a lower interest rate than fixed loans. The risk to the borrower is variable rates could adjust higher if market rates change. The lender often adds a small spread on top of the market rate, which is the total interest cost to the borrower.
If you want to bet interest rates stay low, a variable rate loan might be right for you. However, you need to be aware of the cons that come with this loan. Rates could adjust higher which would increase your monthly payment. It could be challenging to budget if the monthly payment is higher than expected.
Debt Consolidation Loan
A debt consolidation loan is a type of personal loan that combines existing loans into a single loan with a fixed monthly payment. One could choose to use a debt consolidation loan if they have outstanding; medical debt, student loans, car debt, credit card debt, etc.
Debt consolidation simplifies debt management. You may be able to not only consolidate your debt, but reduce your overall interest rate.
Debt consolidation and reducing interest expense are two primary benefits of personal loans.
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 a traditional credit card. Instead of getting a lump sum of cash, you have access to a line of credit to use at your discretion.
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.
Pros and Cons of Personal Loans
Personal loans do offer many benefits and despite their 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, renovate your home, pay medical bills, or pay for a major life event such as a wedding.
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 to a fixed monthly payment.
Easy to Qualify
Although great credit helps, it’s not an absolute requirement. Lenders could issue you a personal loan if you have less than an ideal credit score. However, you might pay a higher interest rate than a qualified borrower. Progressive lenders are going beyond traditional financial metrics to determine a borrower’s capacity to repay.
Personal loans might not be the best option due to the following reasons.
High Interest Rate
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.
If you struggle with debt, access to additional funds could put you deeper in the hole. A personal loan shouldn’t be treated as a security blanket for overspending. Personal loans provide great flexibility, but that can be a problem as it may lead to excessive spending.
Some personal loans have an origination fee, typically ranging from 1-10% of the total loan value. This can be quite costly, and often added to the original amount of the loan. For example, a borrower that qualifies for a $10,000 personal loan could have an original balance of $10,500 (despite only receiving $10,000).
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 through online lenders. These loans allow you to consolidate your debt, save on interest, and provide predictable fixed monthly payments.
Each lender will have their own set of criteria one must satisfy, and there are various loan characteristics to 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.