What is a Personal Loan?
With the barrage of commercials offering personal loans to "fix all your debt" it can be tempting to jump on it and apply. But what does a personal loan do, and how does it change things for you?
Personal loans are one of the most common forms of borrowing, but many people don't fully understand how they work or when they are a good financial choice.
Unlike a credit card, which allows you to borrow repeatedly up to a limit, a personal loan provides a specific amount of money that you repay over a set period of time.
Personal loans can be useful financial tools when used carefully. However, borrowing money without understanding the terms, costs, and repayment plan can create unnecessary financial stress.
What Is a Personal Loan?
A personal loan lets you borrow a specific amount of money and repay it over a set period, usually through monthly payments. Unlike a credit card, which gives you an ongoing line of credit, a personal loan provides the money upfront and establishes a repayment schedule.
For example, you borrow $10,000 for four years.
The lender gives you the money, and you make scheduled payments until the loan is paid off.
Each payment generally includes principal, which reduces the amount you borrowed, and interest, which is the cost of borrowing the money. Depending on the loan, there may also be fees. With a personal loan, your payments will always amount to more than you borrowed, due to the interest and fees, so that $10,000 can really be more like $12,000 (assuming a 5% interest rate).
Personal loans are commonly used for things such as debt consolidation, major expenses, home repairs, medical bills, or other costs that a person can't reasonably cover with cash.
The important part is understanding what you're agreeing to before you borrow. A loan gives you access to money today in exchange for taking on a payment that will affect your budget for months or years.
How Personal Loans Work
Most personal loans are installment loans. You receive a set amount and repay it according to a fixed schedule, usually monthly.
Credit cards work differently. A credit card gives you a revolving credit limit, allowing you to borrow, repay, and borrow again. Your balance and minimum payment can change from month to month.
With a personal loan, you'll generally know:
How much you're borrowing
How long you have to repay it
Your interest rate
Your monthly payment
When the loan is scheduled to be paid off
Personal loans can be secured or unsecured.
An unsecured loan doesn't require collateral. Collateral in basic terms, is something you own of value being put on the line if you don't repay the loan.
The lender instead evaluates factors such as your credit history, income, existing debt, and other financial information when deciding whether to approve you and what terms to offer.
A secured loan requires collateral, such as a vehicle or another qualifying asset. Because the lender has an asset it can potentially recover if you don't repay, secured loans may have different rates or approval requirements. The tradeoff is that the asset can be at risk if you default.
If you put up an item as collateral and the lender has the legal right to take it, refusing to turn it over could lead to legal action. You may also still owe any remaining loan balance if the sale of the collateral doesn’t cover what you owe.
What the Loan Will Actually Cost You
The monthly payment isn't enough information to judge whether a loan is affordable.
Pay attention to four things:
Interest rate: This determines how much interest is charged on the money you borrow.
APR: The annual percentage rate includes the interest rate and certain fees, making it particularly useful when comparing loan offers.
Loan term: This is the amount of time you have to repay the loan. A longer term can lower your monthly payment, but you'll generally pay more interest because you're borrowing the money for a longer period. A shorter term usually means larger payments but less interest over the life of the loan.
Fees: Some loans have origination fees, late payment fees, or other charges. Check whether the loan has a prepayment penalty if you plan to pay it off early.
For example, a five-year loan may have a lower monthly payment than a three-year loan, but the longer loan could cost you more overall. Always look at the total amount you'll repay, not just the monthly payment.
When a Personal Loan Can Help
A personal loan can be useful when you have a specific expense, know how much you need, and have a realistic plan for repayment.
A necessary home repair is one example. You may need the work done now and have enough room in your budget to handle the new payment.
Debt consolidation is another common use. If you have several high-interest credit card balances, a personal loan with a lower APR could combine them into one payment and potentially reduce your interest costs.
But run the numbers first. Compare the interest you're currently paying with the new loan's APR, fees, and total repayment cost.
A personal loan can also make sense for a planned major expense when you know the cost ahead of time and have accounted for the payment in your budget.
The reason for borrowing matters, but so does the repayment plan. Before taking the loan, you should know exactly where the monthly payment will come from.
When a Personal Loan Can Create More Problems
A personal loan adds another monthly obligation, so borrowing to cover an ongoing shortage can leave you with less room in your budget later.
For example, if you're regularly using credit to pay for groceries, utilities, rent, or other basic expenses, adding a personal loan payment may make the situation harder to manage. The loan provides money today, but the payment remains after that money is gone.
The same applies to unnecessary purchases.
Being able to qualify for a $10,000 loan doesn't mean spending $10,000 is a good financial decision.
Sure, that vacation to the Bahamas looks good now. But it won't look so good when you can't pay your rent or electric bill because you're still repaying the loan off.
Sometimes lenders even solicit people, sending out letter saying:
"You qualify for $20,000! Sign here now!"
Well. One, you might not actually qualify once they run the credit reports and ask for income information. And two, why are they trying so hard to get you to sign up? Simple: Because you being in debt, makes them money.
Before borrowing, look at your entire budget.
Consider your current debts, regular expenses, savings, and how much room you have for an additional payment. Most importantly, consider if you really need the loan, or you just would like to have extra money available.
Also consider what would happen if something changed. A reduction in income, an unexpected repair, or another major expense can make a payment that seemed manageable much harder to handle. At that point, you likely won't qualify for another loan to help get you out of the situation.
A lender's approval tells you that the lender is willing to take the risk of lending you money. That doesn't mean you should blindly accept the loan.
How Lenders Decide What They Will Offer You
When you apply for a personal loan, the lender evaluates your financial situation to decide whether to approve the application and what terms to offer.
Common factors include:
Credit score and credit history
Income
Existing debt
Debt-to-income ratio
Employment and financial history
Amount you're requesting
Your credit profile can affect both approval and the interest rate you're offered.
Generally, a stronger credit profile can make it easier to qualify for more favorable terms.
Different lenders use different criteria, so one lender's decision doesn't predict another's.
That's one reason comparing offers can be worthwhile.
If you receive multiple offers, compare the actual numbers rather than choosing based on the advertised monthly payment. A lower payment may come with a longer repayment period and a higher total cost.
Also, inquire if they run a soft-credit check or a hard-credit check. Applying for multiple loans can hurt your credit score, leading to worse repayment terms with each one you apply for.
Before You Sign the Loan Agreement
Shop around before accepting a personal loan. Compare lenders based on the numbers that will affect you over the entire life of the loan.
Make sure you understand:
The amount you'll receive
Interest rate and APR
Monthly payment
Loan term
Total amount you'll repay
All fees
Payment due dates
Any prepayment penalty
What happens if you miss a payment
Any restrictions on how you can use the money
Read the loan agreement before signing it, even if you've already discussed the terms with the lender. The agreement is what determines your obligations. Once you sign it, you are legally bound to those terms.
Failing to repay can not only result in loss of assets, especially in a secured loan, but it can also lead to legal charges brought against you, attempting to collect the balance due. It can hurt your credit, making other areas of your life more expensive as well.
Final Thoughts
A personal loan can be a useful way to handle a specific expense, consolidate high-interest debt, or spread a large cost over time. It also creates a financial commitment that continues long after the money is spent.
Before borrowing, know why you need the money, how much you'll repay, what the loan will cost, and where the monthly payment fits in your budget.
A personal loan is a large legal and monetary responsibility, and while extra money now might sound like a solution, it can instead turn into a long term nightmare if repayment doesn't go as planned.
Up Next: Sometimes getting approved for a loan requires another person to sign with you. In the next article, we'll explain Cosigning, what a cosigner is agreeing to, the risks involved, and what both borrowers and cosigners should understand before signing.
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