Exactly How Do Personal Loans Work?

Posted on March 5, 2021 in Loans

Borrowing money to finance a purchase or consolidate debt is one of the most common aspects of finances. Just about everyone, at some point or another, will need to borrow money for one of these reasons. Whether it’s buying a car or paying off a medical bill, personal loans can be a great benefit for anyone in need of money. Personal loans can be an appealing option to anyone with a good credit score as the interest rates are often lower than alternatives. Additionally, the rise of online lending has allowed those with less than ideal credit rates to be accepted for personal loans. 

For these reasons, it will come as no surprise that in 2018 the total amount of personal loans reached over $138 billion, setting a new all-time high. There are certainly many benefits to taking out a personal loan, but there are also potential drawbacks. Hence, it’s important to know why you need the money and to choose the right type of loan for your specific situation. 

What Is A Personal Loan?

A personal loan is a type of installment loan. These are loans that are a fixed amount of money paid back, with interest, over a set period of time typically measured in months. When the borrowed amount is paid back in full, the account will be declared closed, and the transaction will be complete. Loan amounts will vary from lender to lender, but in general, they range from about $1,500 to $50,000. 

The amount that a person can qualify for is based on a few factors such as their credit score, income, and other debts. The more money someone makes and the higher their credit score than the more money they can borrow. Some of the benefits of personal loans are their fixed interest rates, fixed terms, and fixed payments. Other forms of credit can be harder to manage as they fluctuate in these areas, so many borrowers prefer the set terms of a personal loan.

  • Interest Rate: The interest rate for a personal loan will be set before the loan is even granted and will last for the loan’s entire life. Rates will vary depending on the lender and will also vary depending on the borrower and their specific financial details. A personal loan’s average interest rate will range between around 6% and 36%, but the current average is about 11.8%.

  • Terms: Most personal loans are measured in months as they will become the number of payments. A three-year personal loan would be 36 months and, therefore, 36 monthly payments. A personal loan can have a length, or term, ranging from six months to 84 months. Depending on the term of the loan, the interest rate will be influenced. Typically the longer the term, the higher the rate.

  • Payments: Once the interest and term is fixed, then the payments can be calculated and set. The total amount borrowed, plus interest and fees, will be divided by the loan term and set as equal monthly payments. For example, a $10,000 loan with an interest rate of 12% and a term of 72 months would end up being about $155.55 every month. Having these payments fixed can be much easier to account for and budget around, making repayment more manageable.

  • Origination Fees: Some personal loans come with additional fees included by the lender. This practice is uncommon but not rare, and the fees can range from 1% to 6% of the loan amount.

  • Prepayment Penalty: Another potential fee for a personal loan is the prepayment penalty. In the event a loan is repaid early, there may be a penalty as the lender will miss out on some of the interest they would have earned. 

Different Types Of Personal Loans

There are two different types of personal loans: secured and unsecured. While both are installment loans and relatively similar, there are a few key differences between the two. They each have unique pros and cons and should both be considered when looking for a loan. 

  • Unsecured: The most popular of the two types is unsecured. This means the loan is not backed by any collateral and the lender decides whether the applicant qualifies for their loan based on their financial history. By lacking collateral, interest rates are typically higher for this loan and require a higher credit score to qualify. Lenders take on a more significant risk that the borrower will default on the loan as the consequences of failing to repay an unsecured loan are much less severe.

  • Secured: This loan is backed by collateral such as a house, car, or even savings and investment accounts. Anything a lender is willing to hold as collateral can be acceptable. The way this loan will work is the item will be offered as collateral meaning that failure to repay will result in forfeiture of said item and ownership being transferred to the lender. Lenders will often accept lower credit scores and offer lower interest rates as the risk of someone not paying back a loan is lessened, seeing as how the consequences are increased. 

Where To Find Personal Loans

The most common place to find personal loans would naturally be at a bank or credit union. However, there are many quality personal loans that can be found online as well. For example, the popularity of peer-to-peer lending has skyrocketed over the years and is another available option as well. These loans essentially cut out financial institutions in the loan process as they enable individuals to obtain loans directly from other individuals. 

Also known as “social lending” and “crowdlending,” peer-to-peer lending has been around since 2005. Peer-to-peer lending is when an investor opens an account with a peer-to-peer lending website and deposits money to be dispersed in loans. Loan applicants will post their financial profile that will be assigned a risk category, which will influence the loan’s interest rates. Loan applicants will review the offers they receive and select one, or several, to get the money they need. Money transfers and monthly payments will be handled through the platform, imposing a fee or commission to the lender, borrower, or both. 

While this option can be beneficial, especially for those with poor credit, there are still some risks. If there are any doubts about whether or not a website or lender is legitimate, you should check with the Consumer Financial Protection Bureau or Better Business Bureau before entering personal information or accepting any loans. 

Applying For A Personal Loan

With any financial decision, it’s important to weigh out all available options. After all, this loan will be a part of your financial life for years to come and should therefore not be rushed. These are a few tips to keep in mind when considering a personal loan:

  • Know your needs: It’s important to know exactly how much you will need and why exactly the money is needed. Are there ways to reduce the required total? What amount of money can you afford each month to repay it?

  • Have documents ready: Applying for a loan will require information such as contact information, date of birth, social security number, and employment information such as pay stubs or W-2s. Having these ready can save a lot of time.

  • Ensure you have good credit: This will heavily influence the loan’s interest rate and approval, so make sure the number is suitable before applying. Additionally, the hard credit inquiry required will knock down your score a few points, so be prepared for that as well.

  • Read the fine print: There can potentially be hidden fees, and penalties included that can cost you money. It’s important to read and understand every word of the agreement before accepting. 

How to Get a Personal Loan

Personal loans can be an easy way to get money when in need. There are many options available in terms of lenders and loans, so it’s important to take the time to select the best one suited for you and your financial situation. 

Although arguably the most popular loan type, personal loans aren’t necessarily the best for everyone. Depending on your specific financial details, there may be other loan options that will better fit your needs. Whatever path you select, it’s important to know exactly what you are signing up for and not just read but also understand the details of the agreement.

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