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Personal loans are a popular way to get money to consolidate credit card debt, start a side business, or do some home improvements. In fact, you can use a personal loan to do just about anything. Personal loans are relatively easy to apply for, compared to mortgages or auto loans, and approval is based on your credit history and income.
However, before you apply for one, it’s important that you understand what a personal loan is and how it works.
A personal loan is money lent by a bank or credit union to a borrower in a lump sum. The loan plus interest fees, which are determined by your credit score, are paid back in monthly installments over a predetermined period of time, called the loan term. Unlike other loans meant to be used for a specific type of purchase, such as a home or car loan, personal loans can be used for a variety of purposes.
A personal loan has a few specific characteristics that separate it from other loan products, such as auto loans and mortgages:
Before you start shopping around for a personal loan, there are a few concepts you should be familiar with, in order to be in a position to make the best decision for your financial situation:
There are a few reasons why getting a personal loan could be a smart idea. For example, if you have credit card debt, a personal loan could allow you to pay off your debt and consolidate several smaller balances into one fixed monthly payment. Or, if you want to do some home remodeling, pay for medical expenses, or cover pretty much any other expenses you may have, a personal loan can allow you to finance these things without having to max out credit cards.
The higher your credit score, the lower your interest rate. Most traditional banks require good or excellent credit in order to qualify for a personal loan. Thanks to online lenders, there are options for people with fair and bad credit who need personal loans as well. However, these loans will come with high interest rates, so they might not be worth the cost.
Lenders generally publish a range of annual percentage rates for their personal loan products. It's important to mention that for each lender, the lower end of the APR range is generally reserved for borrowers with excellent credit scores (think 760 FICO® Scores or higher). However, many borrowers (even those with less-than-ideal credit) can obtain personal loans with significantly lower interest rates than they're paying on credit cards.
While all personal loans are in the same overall category, there are some sub-categories you should know:
The short answer is that you can get a personal loan through many financial institutions, both online-based and traditional (branch-based) lenders. If you want to see some of our favorites, check out our updated list of the best personal loans, most of which will allow you to check your APR and loan terms without conducting a hard credit pull.
It can be tempting to select the longest loan repayment term possible in order to keep your monthly payments low. However, I'd strongly advise you to consider repaying your loan in the shortest time period you can reasonably afford.
Let's say that you borrow $20,000 to fund home renovations at an 8% interest rate. Repaying the loan over a 48-month term would result in a $488.26 monthly payment, while a 72-month term would come with a $350.66 payment -- keeping an extra $137.60 in your wallet each month.
However, the longer term would result in you paying $5,248 in total interest, while the 48-month loan would have total interest charges of $3,436. By choosing to pay a little more each month, you'll save yourself $1,812 in the long run.
Applying for one personal loan and accepting the lender's offer without doing any comparison shopping is one of the biggest "rookie mistakes" you can make, and it's easy to see why people new to personal loans make it often. After all, it may seem logical that any particular borrower could expect roughly the same terms from whatever lender they apply to. However, this is 100% untrue.
In fact, it's not uncommon for a borrower to find loan offers with a difference of 8 percentage points or more on their loan's interest rate, even when applying to the best personal lenders. This means that if you apply to a bunch of lenders, offers with APRs ranging from 8% to 16% wouldn't be unusual. Imagine if you had simply applied to the 16% APR lender and accepted that loan agreement.
Furthermore, there's really no good reason not to shop around. Most personal lenders allow you to check your personalized loan offers and get pre-approved, including checking your interest rates, in just a couple of minutes and without a hard credit pull that could hurt your credit score. In other words, an hour or so of shopping around for loans could potentially save you hundreds or even thousands of dollars on a personal loan.
Generally speaking, a personal loan is typically a positive catalyst for the borrower's credit score, assuming they make the loan payments on time.
This is especially true if the personal loan is used to consolidate credit card debt. For one thing, installment debt (loans) is generally considered more favorable than revolving debt (credit cards). Plus, the borrower's credit card utilization percentages will be much lower after the consolidation, which can provide a big boost.
Like any financial product, a personal loan isn't perfect for every situation. For example, if you have the ability and desire to pay off the loan within a couple years, you might be better off using a 0% APR balance transfer offer.
However, if you're looking to consolidate credit card debt, finance home repairs without borrowing against your home equity, or pay for a large purchase, a personal loan is certainly an option that's worth exploring.
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