Personal loans: Everything you need to know

Personal loans can be useful but it's important to understand how they work. (iStock)

Personal loans can be helpful for meeting a variety of financial needs when using a credit card or paying cash isn't an option. A personal loan is a type of installment loan, which means as you make payments the balance goes down until it reaches zero. If you're considering a personal loan for any reason, here's what you can expect.

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Types of personal loans

A personal loan can be secured or unsecured. A secured loan requires collateral, while an unsecured loan would not. For example, some banks and credit unions offer savings secured personal loans, where a savings account or certificate of deposit serves as collateral.

SHOULD YOU GET A PERSONAL LOAN TO PAY OFF CREDIT CARD DEBT?

In terms of what a personal loan might be good for, here are some of the most common uses:

  • Debt consolidation
  • Home improvements
  • Medical bills/expenses
  • Wedding expenses
  • Vacation expenses
  • Moving expenses
  • Vehicle financing
  • Veterinary bills
  • Tax debt

While you might be able to get a personal loan for student loan debt consolidation, that's usually not the best option. If you have federal student loans, for example, rolling them into a personal loan would mean losing the option to defer payments or take a forbearance, if necessary.

Personal loan terms

When checking personal loan offers, it's important to pay attention to the loan terms. Specifically, that means:

  • How long you have to repay the loan
  • The amount you're approved to borrow
  • Your interest rate on the loan
  • Any fees the lender charges for the loan

Personal loans can have a fixed or variable interest rate. Fixed-rate personal loans carry the same rate for the life of the loan. That allows for predictability when budgeting for monthly payments and it's possible to calculate the total amount of interest paid beforehand.

PERSONAL LOAN OR HOME EQUITY LOAN: WHICH IS BETTER?

Variable-rate personal loans can see the rate increase or decrease over the loan term, based on the movements of an underlying benchmark rate. If the rate increases, payments could increase, as would the amount of interest paid.

One of the most significant factors for determining personal loan interest rates is credit history. Lenders are more likely to offer better rates to borrowers with a higher credit score, while a lower credit score might trigger a higher rate.

How to apply for a personal loan

Applying for a personal loan starts with choosing a lender. Remember, personal loans can be offered by banks, credit unions, online lenders and peer-to-peer lenders.

HOW TO GET APPROVED FOR A PERSONAL LOAN

The next step is completing the application. Lenders typically ask for this type of information when applying:

  • Name
  • Address and phone number
  • Date of birth
  • Social security number
  • Employment status and income
  • Requested loan amount and loan purpose
  • Monthly housing payment

Lenders may also ask for supporting documents, such as bank statements or pay stubs to back up financial information. The lender may perform a soft credit pull initially, followed by a hard pull of your credit score and reports.

Pros and cons of personal loans

Personal loans can help close cash flow gaps relatively quickly and for borrowers who qualify for the lowest interest rates, they may be a cheaper alternative to credit cards. They offer flexibility, in that personal loans can be used for almost any reason and excellent credit isn't required for approval.

On the other hand, personal loans may be expensive for borrowers whose credit doesn't allow them to lock in the lowest rates. And some borrowers may be denied altogether if they don't have sufficient credit.

Finally, personal loans may not be an effective debt consolidation tool for borrowers who end up accumulating new debt after taking out the loan.