Personal loans are one of the various forms of credit that can come in handy when making big purchases. Since they have relatively low interest rates, they can also be used to consolidate several high-interest debts like credits cards into one low-cost monthly payment.
Like any other credit, a personal loan is a powerful financing tool but it is critical to consider the impact, advantages, and disadvantages of any credit resource before applying for it. Here are some key things that you should know before taking out a personal loan:
How personal loans work
It is an instalment loan, so you borrow a fixed sum of money and repay it with interest in agreed instalments, typically monthly, over the life of the loan, which normally is between 12 and 84 months. When you settle the total amount, your account is closed and if you need another loan you have to apply again.
Types of personal loans
Personal loans come in two main types:
- Secured loans – These are backed by assets, say houses, vehicles, savings accounts, and others. These loans have the guarantee of recovery from the collateral in case of default, so they have lower interest rates.
- Unsecured loans – These are not backed by any collateral and the lender assesses whether to extend them based on the borrower’s financial history. They have higher interest rates and are suitable for those who need small amounts.
The application process
You go through an application process to get a personal loan. But before submitting your loan application, you should first check your credit report and credit score to get an idea of what lenders will see when they check them. Your credit score is not affected by you checking your credit report, so check as frequently as you need.
After having checked your credit report and taken any necessary action depending on what you see, you can apply for a personal loan through a bank, online lender, credit union, and so on. Lenders typically check your credit report to see the credit score while reviewing your loan application. A higher credit score normally makes you qualify for more favorable interest rates and loan terms for the loans you apply for. Lenders also consider the debt-to-income ratio.
Does this mean that if you have a bad score, all is lost? Certainly not. You can work on rebuilding your credit score by paying all pending bills and loan payments and by engaging experts like Boostcredit101 to help you to repair your score.
Interest rates and other charges
The total that you pay over the life of a loan is determined by the interest rates and fees, and they differ a lot from one lender to another. You should consider the following with regards to the costs of the loan:
Interest rates – This is the direct cost of the loan. Rates usually range between 5% and 36% depending on the lender as well as your credit score. Normally, the higher (better) the score, the lower the rate. Also, the more the months in your loan term, the more interest you are likely to pay.
Origination fee – This is the fee charged for processing the loan that is charged by some lenders. It is typically in the range of 1% to 6% of the loan amount.
Prepayment penalty – This is the fee charged if you settle your loan in a shorter duration than the agreed timeframe. The reason for the fee is that early repayment denies the lender some interest that they may have otherwise earned.
You should get the sum of all of the costs related with the loan before signing on the dotted lines rather than just considering the interest. The sum is what you will be expected to be pay.
Effect of personal loans on a credit score
Once you apply for a personal loan, the lender will pull your credit report for the course of the loan application processing. The pull is referred to as a hard inquiry, and it makes the credit score drop by just a few points.
Bottom line
Although a personal loan is a good option when in need of financing, you should consider some factors like the total amount you will pay by the end of the term loan and the structure of the loan so that you do not get overwhelmed. Other credit options one could consider include lines of credit that you only draw from if need be and you only pay interest for the amount taken out. Another option can be home equity loans that give huge amounts at lower rates while using your house as the collateral.
Picture Credit: mohamed_hassan