Due to the recession caused by the pandemic, lenders are tightening their lending standards and are more critical of who they are lending to.
Like them, you should be wary of new debts – and that means not just credit cards, but personal loans as well.
Let’s take a look at the basics of a personal loan, what it takes to get one, and some of the reasons you might be in the market for one.
How do personal loans work
A personal loan allows borrowers to get money from a financial institution to cover their expenses and later repay them in fixed monthly installments based on a set repayment schedule. “A personal loan is an unsecured loan that provides a borrower with quick access to funds to meet a financial need,” said Brad Calhoun, president and CEO of Teachers Federal Credit Union.
Personal loans are usually unsecured, which means that there is no asset or collateral such as a car or house to secure the loan. Instead, your terms are based on an assessment of your credit history, creditworthiness, and debt-to-income ratio.
The APR or APR can vary widely based on your creditworthiness, so it’s always a good idea to get multiple quotes through pre-approval. Depending on the size and your credit, you may not qualify for a good interest rate – the APR on personal loans can range from 3.49% to 35.99%. (For context, the average credit card rate, according to the Federal Reserve, is 14.52%.)
Personal loans also come with fees. These can include processing fees (a one-time cost you usually pay when you get the loan), prepayment fees (which you will be charged if you pay back the loan early), and late payment fees (if you are ever late). So before you apply, be sure to check out various lenders to avoid these fees – or at least pay as little of them as possible.
Unlike most credit cards, which offer variable interest rates and perpetual terms, personal loans are often offered at a fixed rate over a fixed term that you can request based on your needs. The terms can be between 6 months and 5 years.
While many stationary banks still offer personal loans, you may not need to show up at your local branch to apply for one. Financial institutions have prevailed online and often compete with one another to offer the best possible prices, giving consumers more choice.
Make sure to apply for the amount you need and nothing more. Otherwise, you will have to pay interest on a larger loan balance.
5 reasons for a personal loan
Here it can make sense to think about a personal loan:
1. Debt Consolidation
While you can use credit cards to get you through tough times, those interest rates can add up – and before you know it, you’re juggling multiple payments to multiple banks. “Personal loans can be a great way to consolidate credit card debt at a lower rate,” said Kyle Gibbons, financial advisor at KSGibbons Consulting in New York City. You should only consider consolidating credit card debt with a personal loan if the APR on your personal loan is less than the current APR on your credit card.
2. Hospital bills
Medical bills can creep in, and if you’re not careful and forget to pay, they can affect your credit score. Using a personal loan to pay these bills could help you deal with fees from unexpectedly high deductibles and insurance co-payments. This doesn’t just include visits to the emergency room. Cosmetic surgery, dental work, or even fertility treatments – which may not be covered by insurance and usually need to be paid for in advance – can be done with a personal loan to cover costs and paid back monthly.
3. House remodeling
Many of us now work from home, or at least spend a lot more time within the four walls of our home. Perhaps you look around your kitchen thinking these cabinets need a refresh. Personal loans are a much lower risk alternative to a home equity line of credit as they are not tied to your home and can even help you add value to your home. This can help you get the pool, deck, or garage extension you have dreamed of.
4. Car repairs (but not new cars)
The dreaded check engine light just popped up on your dash and you are now at the mercy of a mechanic. After learning that your car needs thousands of dollars in repairs, a personal loan can give you the confidence to cover that emergency. When it comes to buying a new car, it can be tempting to take personal loans for that too. But make sure to check out your options before jumping in. Terms, prices, and fees are usually much more affordable when you get a car loan as your new car becomes a security.
5. Unexpected expenses
Life can give us all a curve ball every now and then. So, unless you have an emergency fund in place, it can be difficult to recover from unexpected expenses. Without that safety net or a well-designed financial plan, you might need help, and a personal loan can provide the quick, flat-rate payment needed to stay afloat while things return to normal. Just make sure that you only request the amount you need and that you can easily afford the repayment.
What are the requirements for a personal loan?
While every bank, lender, and online lender have different application requirements based on their own risk tolerance, the process is pretty similar. In general, however, the interest rate offered is based on your creditworthiness – and the interest rates are usually higher than other types of credit.
“The interest rates are likely higher than a car loan or mortgage,” said Lauren Bringle, an accredited financial advisor at Self Financial. “To qualify for a personal loan, especially one with the best interest rates, you need a good credit rating. Lenders also check your income and total debt to income ratio to make sure you can pay back the money you borrowed. “
In order to apply, you will need to provide some personal information, such as your full legal name, date of birth, address, citizenship status and social security number. You will then be asked for some details about your finances, such as employment status, income, education level, home ownership status, and the purpose of your loan.
One important consideration, says Bringle, is making sure you have the extra headroom to make the payments within your budget. “When you decide to take out a personal loan, make sure that your loan is in good condition and that you can afford the monthly loan payments in addition to your other bills. Lenders only look at other debts on your credit report when checking your repayment eligibility and don’t consider other bills like transportation, groceries, daycare, and utilities.
Whatever your personal situation, before applying for a personal loan, weigh your options and make sure that a personal loan makes sense for your situation. Here are some of the main reasons people take out personal loans.
Before starting your application, make sure you have at least the following on hand:
- Proof of identity – usually a passport, driver’s license, or birth certificate.
- Proof of income – such as pay slips, W2, bank statements or tax returns.
- Proof of address – such as an electricity bill, a rental or lease agreement, or a voter card.
Good creditworthiness and on-time payments are critical to obtaining a personal loan. As with any other type of loan, be sure to check your repayment ability before pulling the trigger. There are many financial institutions that offer personal loans both online and at your local bank branches so make sure you shop for the best rates available.