How do personal loans work? (2023)

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Credit cards aren't the only option when it comes to financing purchases or consolidating debt. Personal loans are a popular choice thanks to digital offers that simplify application and approval.

But before you sign the dotted line, you need to make sure the personal loan is right for you. To do this, you need to understand the inner workings of this lending tool. You don't want to end up with an expensive loan that you don't understand or aren't prepared to pay.

Go back ten years when consumers had fewer opportunities to borrow money. They could use a credit card, which often meant high interest rates, or apply for a bank loan, which was difficult to obtain without preferential credit. The 2008 recession changed that.

(Video) Personal Loans Explained (what is a personal loan and how does it work)

With banks offering little consumer credit, several financial technology (or FinTechs) startups have emerged to offer consumers something.personal loans. They used various data and underwriting algorithms to predict risk and created a market that is now booming.

Unsecured according to TransUnion, the credit score companyPersonal loans hit $138 billionreached an all-time high in 2018, with much of the growth coming from loans from FinTech companies. Average loan size in Q4 2018: $8,402. Fintech lending accounts for 38% of total activity in 2018; five years ago, it was only 5%.

Related:Compare personal loan rates

How personal loans work

Personal loans come in many flavors and can be secured or unsecured. A secured personal loan requires you to provide collateral or asset in case you are unable to pay back the money owed. If you default, the creditor gets that asset. Mortgages and car loans are examples of secured debt.

(Video) Personal Loans 101 (Debt Management 4/4)

More common with an unsecured loanPersonal Loan Type, you do not need to provide any guarantee. If you do not return the money, the creditor cannot confiscate your assets. This does not mean that there are no effects. If you default on an unsecured personal loan, youdamage your credibility, which in some cases dramatically increases borrowing costs. And the creditor can file a lawsuit against you to collect the outstanding debt, interest and fees.

unsecured personal loansare typically used to finance a large purchase (like a weddingor vacation) to pay off or consolidate high-interest credit card debtstudent loans.

Personal loans are issued as a lump sum that is deposited into your bank account. In most cases, you will have to repay the loan at a fixed rate over a certain period of time. The payback period can vary from one year to ten years and varies from lender to lender. For example, SoFi, an online lender, offers personal loans with terms ranging from three to seven years. Goldman Sachs rival Marcus offers loans with maturities of three to six years.

Borrowers who are not sure how much money they need can also take out a personal line of credit. This is an unsecured revolving line of credit with a predetermined credit limit. (In this respect, it is very similar to a credit card.) The interest rate on a revolving line of credit is typically variable; H. changes with the current market interest rate. You only pay what you took out of the loan plus interest. Lines are often used toDIY work, overdraft or for emergency situations.

(Video) Loans 101 (Loan Basics 1/3)

Your credit score determines the cost of borrowing

When considering whether a personal loan makes sense, you need to consider your credit score. It's a number between 300 and 850 that indicates how likely you are to pay off your debt based on your financial history and other factors. Most lenders require a credit score of 660 for a personal loan. With lower credit scores, the interest rate tends to be too high to make a personal loan a viable loan option. A credit score of 800and aboveget the lowest interest rate available on your loan.

Many factors are taken into account when determining your credibility. Some factors are more important than others. For example,35% of FICO-Scores(the type used by 90% of the country's lenders) is based on your payment history. (Other FICO facts areHere.) Lenders want assurance that you can borrow responsibly and will look at your past behavior to get an idea of ​​how responsible you will be in the future. Too many late or missed payments is a big red flag. To keep this part of your score high, make all your payments on time.

The second is the amount of outstanding credit card debt in relation to your credit limits. This represents 30% of your credit score and is known in the industry as the credit utilization rate. It will check how much credit you have and how much is available. The lower this ratio, the better. (For more seeThe 60 Second Guide to Using Credit.) The length of your credit history, the type of credit you have, and the number of new credit applications you have recently filedother factors that determine your credibility.

In addition to your credit score, lenders look at your income, employment history, cash and cash equivalents, and overall debt levels. They want to know if you can pay back the loan. The higher your income and assets and the lower your other debts, the better you look them in the eye.

(Video) The Pros and Cons of Personal Loans

Good credit is important when applying for a personal loan. It not only determines whether you'll be approved, but also how much interest you'll pay over the life of the loan. According to ValuePenguin, a borrower with a credit score between 720 and 850 can expect 10.3% to 12.5% ​​on a personal loan. This increases to 13.5% to 15.5% for borrowers with credit scores of 680 to 719 and 17.8% to 19.9% ​​for borrowers in the 640 to 679 range. can be approved. Interest rates at this level range from 28.5% to 32%.

There is a commitment

Personal loans can be an attractive way to finance a big purchase or pay off credit card debt or other high-interest debt. The terms are flexible so you can create a monthly payment that fits your budget. The longer the term, the lower the monthly payment.

But there is a compromise. You pay interest longer. Also, the longer the term of your loan, the higher the interest rate on the personal loan.

Take a personal loan from SoFi as an example. On a $30,000 loan, a borrower with the best credit ratingpays 5.99%for a three-year loan. it starts9,97%for a seven-year loan.No Citizens Financial Groupthe interest rate is 6.79% for a three-year loan and 9.06% for a seven-year loan. At LightStream, a unit of SunTrust Bank, the interest rate for a three-year loan starts at 4.44%. Expect interest payments of 5.19% for seven years.

(Video) Should I Move Credit Card Debt To A Personal Loan?

In addition to the interest rate, some lenders charge a loan origination fee, which represents the cost of processing your application. This can make borrowing costs more expensive. The good news: origination fees are starting to disappear, especially on digital platforms. Online lenders that do not charge borrowers origination fees include SoFi, LightStream, Marcus By Goldman Sachs, andErnst. All require a minimum credit rating of 660. When shopping for a personal loan, compare the APR or the APR. It includes the interest rate and fees to give you a complete picture of how much you will pay.

If you have a good credit rating, a personal loan is a sensible way to finance a big purchase.consolidate debt. If your credit score is below average, it might be worth paying a higher interest rate if it means you can get out of even bigger debt. Before taking the leap, do the math. Consider the interest rate, fees and terms. If you end up paying thousands of dollars to consolidate your debt, this is not the best option for you.


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