In life, everyone has to make tough financial decisions. Whether you have debt to consolidate or plan to make a large purchase, you may be considering taking out a personal loan.
When it comes to personal loans, people have a lot of opinions. Your friends, family, or financial advisors will likely tell you that there are "good" reasons to take out a personal loan and foolish ones. But why? And what makes personal loans any different from student loans, mortgage loans, or car loans? If you think you may need a personal loan but don't know how they work or if they make sense for your situation, keep reading to learn the basics.
How Do Private Loans Work?
Unlike many other types of loans, personal loans are unsecured, meaning you don't back them with any form of collateral. Because the lender has to account for higher risks with unsecured loans, they tend to have higher rates. According to research by Nerdwallet, personal loans typically spread fixed installments across two to seven years and have an annual percentage rate (APR) of six to 36 percent. To determine interest rates, lenders consider your debt-to-income ratio (DTI), credit score, and credit report.
How Can You Use a Personal Loan?
While student loans, car loans, and mortgage loans apply to specific types of debt, personal loans can help you pay for virtually anything. However, that doesn't mean you should take out a personal loan every time you want something you can't currently afford. Financial experts only recommend using personal loans when it's a less expensive option than other forms of credit, and you can reasonably afford the monthly payments.
Common reasons to take out a personal loan include:
- Consolidating high-interest debt
- Refinancing student loans
- Adding value to your home (remodeling)
- Emergency expenses, such as medical bills or funeral costs
- Financing business expansion
- Furthering your career (ex: taking courses that will help you get a new job)
When not to take out a personal loan:
- Financing a luxurious wedding or vacation that you couldn't afford otherwise
- Purchasing expensive items that you want but don't need
- Making risky investments
- Taking out a loan solely for the purpose of lowering your credit score
All Things Considered
Before applying for a personal loan, you want to make sure that you can afford the monthly payments and have a strong enough credit history to qualify for reasonable rates. You may want to consider the following questions:
- Do you have stable employment or other forms of income? Can you count on having this income for the full duration of your payment plan?
- Has your credit score dropped recently?
- Do you need someone to co-sign the loan? If so, can you think of anyone who would?
- Would another type of loan better suit your needs? (Depending on what you plan to use your loan for, it may make more sense to take out a purchase-specific loan.
How to Find the Right Loan for You
Once you've decided that using a personal loan makes sense for your situation, you should do your due diligence to find the right personal loan lender and affordable rates. When shopping around for the right lender, you should compare:
- Interest rates
- Origination fees and other additional fees
- Minimum credit score qualification
- If they offer pre-qualification
- If they can make direct payments to creditors
- Payment options (some lenders allow variable rates)
- Flexibility in payments (Some lenders allow you to reschedule a payment, some will pause your installments if you lose your job, etc.)
- Fees for late payments
- Ways to lower your interest rate over the course of your repayment schedule
- Reviews from borrowers
- Additional financial services, resources, tools, and education
How to Improve Your Chances of Approval
As you search for the right lender, you may also want to take a few steps to improve your odds of approval. However, you can't change all of these factors overnight; you may find that you need to put your purchase or debt consolidation on hold while working on these areas.
- Raise your credit score by checking your reports for errors, requesting an increase on your credit limit, and making your bills and credit card payments on time for consecutive months
- Look for supplemental income to help pay off existing debts
- Lower the amount you're asking for
- Consider a co-signer
Making a Personal Decision
Once you've considered all the elements discussed above, you're ready to make a final decision and start applying for your personal loan. Remember, everyone has different financial circumstances, so what works for other borrows may not work for you. Taking out a loan is a personal decision with considerable consequences, so weigh your options carefully and take your time making a choice.