Takeaways
- Personal loans can help you get fast cash for a major purchase.
- Financial planning can help determine if taking out a personal loan makes sense.
- The cost of a personal loan depends on your unique credit history.
- Getting in financial shape before you apply for a personal loan can save you money.
- There are a variety of pros and cons to using a personal loan.
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A personal loan is a form of debt financing to help purchase large ticket items or to consolidate debt. Banks and other lenders typically charge lower interest rates than credit cards for customers with good credit scores.
What is a Personal Loan?
Personal loans are a type of debt that allows you to use your loan for many items. You can use a personal loan to invest in remodeling your home, paying for unexpected expenses, or even paying medical bills.
Banks, credit unions, and other lenders offer a variety of personal loans based on your credit score and history of paying off debt. Personal loans can vary in size, interest, and maturity. Let’s analyze the key components of a personal loan.
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Key Factors to a Personal Loan
Getting a personal loan is like taking out an auto loan or credit card because lenders allow you to pre-qualify online and peruse interest rates before officially applying for a personal loan. After you are prequalified, you can vet personal loans to see if they make financial sense. If you officially apply for a personal loan online, lenders will make a hard inquiry on your credit report, impacting your credit score.
Personal loans have the same components as traditional loans. Here are the key variables to analyze.
1. Principal Amount: The principal is the total loan you are attempting to borrow. Principal amounts vary widely based on the use case for your loan. If you are remodeling your house, this can range from thousands to hundreds of thousands of dollars. But if you are paying off a tax or medical bill, it could only be a couple thousand dollars.
2. Interest Rate: Your interest rate is expressed as a percent and is the amount your bank, credit union, or lender charges to finance the loan. Lenders charge interest rates that vary based on your credit score and credit report.
3. Monthly Payment: Your monthly payment will be a single payment comprised of interest and principal payments (like mortgage payments). Monthly payments are calculated based on the principal amount, loan term, and interest rate.
4. Repayment Terms: The repayment term is the length of time before you are obligated to repay the loan. Repayment terms are used to calculate your loan amortization schedule and monthly payments. The range of repayment terms varies based on the loan you secure but typically falls between one to five years.
Smart Tip:
Before applying for a personal loan, it makes sense to boost your credit score and check your credit report for any errors. The most favorable loan terms are provided to those with the highest credit scores. Improving your credit before applying for a personal loan will help you get the best personal loan possible.
Is It Smart to Get a Personal Loan?
Everyone’s financial situation is different. Personal finance experts generally advise against taking out too much debt. A high debt-to-income ratio can be a bellwether for an inability to pay debt on time.
A personal loan can certainly make sense in some situations. For example, a personal loan can make financial sense if you have a relatively low debt load (minimal balances on credit cards, student loans, or auto loans), need cash quickly (to make a purchase or pay off a bill), you can afford the monthly payments and has low borrowing costs.
7 Reasons to Apply for A Personal Loan
There are many reasons to apply for a personal loan. Here are seven common scenarios to secure a personal loan:
1. Home Remodels
The use case for personal loans is most profound with home renovations. If you need to remodel a kitchen, add a room, or paint your house taking out a personal loan could be a perfect fit. Compare the cost of borrowing for these high-cost projects and ensure you get the best interest rate on your loan.
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Don’t forget about regular repairs to your house. You might need to rewire your house, install new pipes, or fix the gutters. This upkeep is part of homeownership, but if you squeaked by affording to buy your first home, these expenses could catch you off guard.
2. Medical Bills
Unplanned medical bills can be a source of financial strain. Even if you have an emergency fund to hedge against unforeseen expenses, medical emergencies, and their associated bills can catch you off guard. You can consider using a personal loan if you can get a lower interest rate on the personal loan than from a medical center payment plan. Paying your medical bill with cash is the preferred route.
Smart Tip:
Do you know your out-of-pocket expenses with your healthcare plan? Understand the maximum cost of premiums for a considerable accident because planning on medical emergencies will alleviate the need for a personal loan.
3. Unexpected Expenses
There are plenty of ways to earn cash quickly. If you are in a cash-only situation or need money to make a larger purchase, taking out a personal loan might be the best option. In the case of an emergency, your emergency funds might only pay for part of the bill. Other sources of quick cash, like payday loans, are more expensive than personal loans.
4. Large Extraordinary Expenses
When you don’t have the cash upfront to make large purchases, like a washing machine, computer, mattress, or other appliances, you can use a personal loan to make that purchase. Check your budget to ensure you can comfortably make your monthly payments and that the personal loan fits within your long-term financial goals.
5. Moving Expenses
Moving expenses can cost you thousands of dollars unless you are moving for a new job and your company sponsors the move. If you are self-funding your move to (or from) a large city, your moving costs can be very high. Taking out a personal loan to cover these expenses can reduce the headache of moving.
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6. Tax Debt
Tax debts are not fun. Accidentally underpaying your prior year’s taxes can be a scary situation. This sudden demand for cash can throw you off your economic footing.
Personal loans offer a way to bridge the gap and take out a loan to pay off your IRS debt. Instead of owing the IRA, you will owe your lender. You still must compare your IRS installment plan, interest rate, and fees to your loan. If the personal loan is the cheaper option, it makes sense to pay off your tax debts with the loan as quickly as possible.
7. Debt Consolidation
Another major use case to take out a personal loan is if you have super high-interest credit cards and other debts, which you can consolidate into a lower-interest rate personal loan. Debt consolidation can help you save on interest payments.
Learn More -> What is Debt Consolidation?
Before consolidating your debts, analyze the options to ensure creating a whole new loan (e.g., a personal loan) is the best solution. Sometimes, implementing an aggressive debt repayment strategy can save you time and money.
How to Get a Personal Loan
Improve Your Credit Score: Review your credit score before applying for any credit. Look for ways to improve your credit score quickly because this will reduce the interest costs you will have to pay over the life of the loan. By boosting your credit ahead of time, you can set yourself up to get the best personal loan.
Pre-Qualify: Once you have boosted your credit score, it’s time to do your homework and compare personal loan options available to you. To do this, you need to calculate how much you want to borrow (your principal) and estimate the interest rate you are willing to pay.
After you have this information, you can pre-qualify to review potential personal loan offers. Importantly, by pre-qualifying you only allow potential lenders to conduct a soft credit check, which doesn’t impact your credit score. Be sure to get quotes from a variety of lenders – banks, credit unions, and online lenders.
Compare Your Options: Depending on the rates offered to you during the pre-qualification process, a personal loan might not be your best lending option. Better options could include 0% interest credit cards or secured loans. Before you sign anything or formally apply for a personal loan, make sure to read all the fine print and read up on your lender.
Formally Submit Application: Next, it’s time to formally submit your personal loan application. Gather the appropriate required loan documentation and apply for the loan. This will likely entail a hard credit inquiry. Once approved, you will receive the cash for the principal amount in a matter of days.
Make Your Purchase: After you have been formally approved, your bank account will be funded for the principal amount. Now, it’s time for the fun part. Purchase those new appliances or get with your contractor to start your renovation project.
Start Monthly Payments: Your repayment process will be set into motion once your loan has been officially approved and funded. Make sure you have appropriately budgeted to handle your monthly loan repayments.
Pros of Personal Loans
Personal loans can offer you access to cash quickly to help make high-cost purchases. Here are some factors that make taking out a personal loan an attractive financing strategy:
Personal Loans Are Highly Versatile: There is a variety of industry-specific loans. For example, if you want to purchase a house, you apply for a mortgage. If you need a new car, you get an auto loan. But if you want to secure a loan that can fund nearly any purchase, a personal loan could be right for you. Now, lenders will ask about the purpose of your loan but will not be likely to disqualify you for your reason. This makes personal loans highly versatile.
Fixed Monthly Payments: Monthly payments can be a pro and a con. For the financially prepared, fixed monthly payments over the life of the loan allow for better cash flow planning for your budget. Unlike other forms of debt, like credit cards, which fluctuate month over month. A personal loan amortization schedule gives you an exact picture of what you own and when payments are due.
Low Annual Percentage Rates (APR): Borrowers with good to excellent credit scores can usually secure low-interest rate personal loans. These interest rates tend to be much lower than short-term debt options like credit cards, where annual percentage rates can be very high.
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Easy to Manage: Low-interest rate personal loans can make sense for consolidating multiple high-interest credit cards or other outstanding debt. If you can secure a lower interest rate personal loan compared to your other debt, the personal loan can add thousands of dollars of interest payment back into your pocket. Having one loan to manage makes your debt repayment easier to manage. One fixed-rate monthly payment will reduce the financial clutter in your life.
Get Cash Fast: A personal loan can be a fantastic financing option if you need cash fast. The loan application approval time can be expedited in only a few days (if you have good credit). The speed of funding can make personal loans ideal for situations where you need cash quickly.
Cons to Personal Loans
Applying for a personal loan isn’t always necessarily the best financial decision. Weigh your short-term and long-term financial goals and contemplate adding more debt into your financial ecosystem. Do your due diligence and consider the cons of securing a personal loan. Here are a few items to consider:
Personal Loans are New Debt: A personal loan increases your debt load and debt-to-income ratio. A high debt-to-income ratio can hamper your ability to get the best credit cards or mortgage rates. If you consider consolidating debt with a personal loan, you are essentially trading high-cost debt for lower-cost debt. This does not address why you have too much debt.
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Don’t Forget Origination Fees: Many personal loan providers charge an origination fee, which is expressed as a percentage of your total loan amount. Depending on your loan provider, origination fees can range from 1%-10%. Origination fees compensate lenders for processing your loan application and sending you the personal loan amounts.
Smart Tip:
You can negotiate with your lender of choice and eliminate origination fees if you have a great credit score. Try to increase your credit score before taking out a personal loan.
Additional Monthly Debt Payments: Personal loans can provide the cash to purchase new appliances and help pay for home improvement projects. This new loan, however, means that you will have to pay monthly debt payments for the term of the personal loan. These monthly payments can wreak financial havoc on your budget.
Consider Lower Cost Options: While personal loans provide an opportunity to purchase expensive items, professional finance experts warn against using personal loans if you can get lower-cost options. Interest rates on personal loans vary and are not always the lowest-cost option, especially if you have poor credit. The lower your credit score, the higher the interest rate lenders will charge and the more interest rate payments you will have to make over the life of the loan.
Smart Summary
Getting a personal loan is a decision that should be considered in the context of your overall financial goals. Adding too much debt to your financial ecosystem can tilt your debt-to-income ratio off balance. Do your research and figure out the best financing opportunity available. If that means getting a personal loan, lay the groundwork for securing the best personal loan possible. Consistently trying to lower the cost of any debt is a smart money habit.
Frequently Asked Questions
Personal loans are unsecured loans. Unlike mortgages or auto loans (backed by a physical asset like your house or car), personal loans offer no collateral. Lenders have fewer options as recourse should you fail to pay your loan. To compensate them for that risk, they charge a higher interest rate. As a result, personal loans make more financial sense for people with a high credit score and can therefore command lower interest rates. If you have a low credit score, the interest rate lenders charge is so high it often negates the practicality of getting a personal loan.
Lenders will want to verify your identity and income. The documentation typically needed will usually be:
- Divers License, Passport, or other form of identification
- W-2, Pay Stub, or Bank Statement or Other Proof of Income
- Personal Address, supported by a mortgage statement or utility bill
Your loan term determines how long you must pay off your personal loan. The loan term is usually expressed in months and usually from 12 to 72 months or more. A prepayment penalty fee may apply to your loan. Check with your lender to see if you can pay off your loan early. Prepayment fees are typically a point you can negotiate.
