What to Know About Unsecured Personal Loans

Personal loans are more plentiful than ever, so here’s what you should know.

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The personal lending industry has grown tremendously in recent years. Unsecured personal loans can help people get out of debt faster and finance personal expenses without using credit cards. However, like many fast-growing industries, unsecured personal loans aren’t well understood by many Americans. With that in mind, here’s a rundown of what you need to know about unsecured personal loans.

What is an unsecured personal loan?

A personal loan simply refers to a loan made from a financial institution to an individual, for virtually any purpose besides buying a home, a car, or for paying college tuition. Many personal loan borrowers use their loan funds to consolidate other debts, such as credit card debt. Others use personal loans to finance personal expenditures, such as home renovations or medical bills.

The term unsecured simply means that no collateral is required to obtain the loan. This is in contrast to auto loans or mortgages, which are secured by the underlying automobile or home.

It’s also important to point out that personal loans are amortizing loans, meaning that they have a fixed number of payments until they are paid in full, unlike credit cards.

You can check your personal loan offers easily

One important thing to know about unsecured personal loans is that it’s easy to see if you qualify, and, if so, what interest rate, maximum loan amount, and other terms you can expect to receive. The vast majority of personal lenders have a quick pre-qualification process, during which they’ll conduct a soft credit pull (that doesn’t affect your score).

It’s important to check your offers from several different personal lenders, as rates and fees can vary dramatically between lenders. It isn’t uncommon to find an 8 or 9 percentage-point spread between your best and worst loan offer, so taking the time to shop around can potentially save you hundreds of dollars or more.

How to apply for an unsecured personal loan

The actual application for a personal loan is a bit more complicated than the pre-approval process but is still quite painless compared with the old process of obtaining a personal loan from a bank.

During the application process, you’ll have to fill out a form with some important personal information about yourself, and you’ll probably be asked to upload supporting documentation. While different lenders have different requirements, here’s a basic list of what you should have available in case it’s requested:

• Your driver’s license, other state-issued ID, or U.S. passport.
• Your Social Security card, or at least a copy of it.
• Proof of your income, such as your most recent W-2s and pay stubs, or 1099s if you’re self-employed. Lenders may also want to see your recent bank statements, especially if you’re self-employed.
• Your bank’s routing number and the account number where you want the loan proceeds to go. Some lenders offer a discount if you agree to have your loan payments automatically drafted from your bank account, so you’ll need this information for this purpose as well. And, the deposit and payment accounts don’t necessarily need to be the same.
• Your last few tax returns. Not all lenders want these, but it’s a smart idea to have them available anyway.

How much interest will you pay?

While personal loans offer generally lower interest rates than you’d get with a credit card, this isn’t true in every case. As I alluded to in the pre-approval discussion, interest rates vary dramatically among personal lenders. For example, popular personal lender Prosper offers personal loans with interest rates ranging from 6.95% to 35.99%. That’s a big spread. An interest rate towards the lower end of that range will almost certainly save you money over credit card interest. On the higher end -- not so much.

Having said that, here are the factors that will determine your interest rate when applying for a personal loan:

• Your lender’s range of interest rates.
• Your credit score. This is the most important factor in determining your interest rate.
• Your other debts, your income, and your employment history.
• The length of your loan term. All other things being equal, shorter loan terms generally get better interest rates.
• Your loan amount.
• Whether you agree to pay automatically. Many personal lenders offer a small interest rate reduction if you agree to auto-pay your loan payments.

Fees and other costs of unsecured personal loans

Many personal lenders pride themselves on charging no fees whatsoever, while others do have various costs associated with them. In addition to the obvious expense of interest, here are some other fees you may encounter while shopping for an unsecured personal loan:

Origination fees -- This is a fee that is charged when you obtain a personal loan, and many lenders with origination fees deduct it from the loan’s proceeds. In other words, if you borrow $10,000 with a $200 origination fee, you can expect $9,800 to show up in your bank account.

Prepayment penalties -- Although these are quite rare, prepayment penalties do exist. These are fees that a lender charges you if you decide to pay your loan back early. The rationale is that by making a loan, the lender is expecting a certain amount of interest income. Since your lender won’t get all of its interest income if you pre-pay, a prepayment fee is designed to somewhat offset that.

Late payment fees -- Many personal lenders charge an additional fee if you make a monthly loan payment after the due date.

Do you need great credit?

Having excellent credit will certainly help you take advantage of the best personal loan offers available. If you have downright bad credit, you’re unlikely to get a personal loan.

Having said that, there are several personal lenders that specialize in loans to consumers with fair credit scores. For example, personal lender Avant accepts borrowers with FICO® Scores as low as 580, which is actually at the bottom end of what’s considered “fair” credit. Other lenders such as Upstart and Lending Point also accept borrowers with so-so credit scores.

To be clear, you aren’t likely to get a single-digit interest rate on your personal loan unless you have good credit. However, personal loans can still be great financial tools for borrowers with less-than-excellent credit scores.

An unsecured personal loan can be good for your credit score

Speaking of credit scores, it’s also important to note that a personal loan can boost your credit score if you’re using it to consolidate credit card debt.

Without going too deep into a discussion of how the FICO credit scoring formula works, the amounts you owe on your various credit accounts makes up 30% of your score. And generally speaking, installment debts, like personal loans, are counted more favorably in the FICO formula than revolving debts, like credit cards. So, by shifting your debts from revolving to installment accounts, it can significantly boost your credit score.

As a personal example, I obtained a personal loan a few years ago to consolidate a few credit card balances, and although the dollar amount of my debt didn’t change, my FICO® Score shot up by 30 points shortly after the loan was completed.

Unsecured personal loans versus credit card balance transfers and 0% APR offers

A personal loan can be a smart way to consolidate credit card debt and pay for personal expenses, but it’s not the only money-saving option on the table.

Competition has never been higher in the credit card industry, so there are some pretty impressive 0% APR offers for both purchases and balance transfers. There are several credit cards on the market that offer promotional 0% APR periods of 18 months or more.

The point is that if you feel confident that you can repay your credit card debt or pay for the expense you want to finance in full before the 0% APR period runs out, a credit card promotional APR could be the smarter way to go. Keep this in the back of your mind as you’re considering a personal loan.