Thousands of people take out personal loans every day for a variety of reasons. Even so, personal loans are not for everyone. There are multiple factors to consider before taking out a personal loan.
From emergencies to individual purchases, personal loans are an excellent option when you don’t have enough cash in hand on a specific occasion. Each personal loan application is unique, so you’ll need to be well-versed in what you need to apply.
Other factors to consider are your credit history, interest rates, fees, and your ability to pay back the personal loan in the future. We’ll break down all of these considerations and more today.
Reasons for Taking Out a Personal Loan
Personal loans are built for people who need a certain amount of money on one particular occasion. These personal loans are repaid over a set amount of time, which is why they are also called installment loans.
While it should be evaluated on a case-by-case basis, it’s important to only consider a personal loan if your expense is truly necessary. Irresponsibly taking out a loan is sure to cause financial woes down the line, so analyze your situation carefully before deciding.
People may take out personal loans for a wide array of reasons. Some of the most common reasons are listed below.
For those with limited or no health insurance, unforeseen medical expenses may warrant taking out a personal loan. These can also include medical expenses that aren’t covered by insurance, such as fertility treatments.
One’s health and well-being should always be prioritized, so consider taking out a personal loan if needed to access adequate health care today.
Home or Car Repairs
Housing and transportation come on the list of needs for our daily lives. If the water heater breaks in winter or a storm damages the side of your home, you’re going to need repairs, fast. The same goes for a broken-down vehicle on which you and your family rely.
You may lack the emergency fund necessary to deal with these repairs, or perhaps your fund doesn’t cover the total cost. In these cases, an optimal option would be to take out a personal loan to help pay for the repairs.
Some individuals choose to take out personal loans for large purchases, such as a wedding, vacation, etc. While this is a personal choice, it’s important to consider if it’s indeed the wisest choice to make.
Certain bigger purchases, like large home appliances, cannot wait. Others, like that beach vacation, may be better off postponed for a few more months.
Types of Personal Loans and Their Requirements
There are different types of personal loans, each with its own set of requirements set by lenders. Generally, all personal loans require a government ID to verify your identity and age.
Other paperwork may include proof of income or other documentation of your current financial situation. These typically include pay stubs, W-2 forms, a salary letter, or tax returns.
Not all loans are created equal. We will break down the most common personal loan types and their specifications below.
Unsecured Personal Loan
Unsecured personal loans are the most common type of loan. For this loan type, no collateral is required.
While this makes it easier for you, the borrower, to access the loan, it also makes it more difficult for the lender to have a guarantee that you will repay it. If you fail to make the monthly payments, the lender does not have any physical assets to seize from you.
Because of this, unsecured personal loan lenders look for reliability when it comes to the borrowers they approve. You will need a good credit score to receive an unsecured personal loan, typically at least in the high-600 range.
Since it is seen as a riskier loan on the lender’s part, you’ll have to truly ensure you can and will pay back the loan. If you fail to make the payments once you have an unsecured personal loan, it could dramatically affect your credit score.
Secured Personal Loan
Secured personal loans are the other side of unsecured loans. They require collateral for approval. This collateral could be one of many assets in your possession, such as your vehicle, savings account, or even a certificate of deposit (CD).
These loans do not require as high of a credit score as unsecured loans, so more individuals are eligible. This means all you need is your asset.
Lenders require collateral for secured personal loans to ensure they have insurance if you fail to make the monthly payments. For example, if you were to fail repayment and placed your vehicle as collateral, your car would be repossessed by the lender.
Since this collateral offers less risk for the lender, the borrow is benefited by lower interest rates on secured personal loans compared to unsecured.
Adjustable-Rate Personal Loan
These loans are not as common as fixed-rate or unsecured personal loans, but they can be found with certain lenders. Also called variable or float-rate loans, adjustable-rate loans have interest rates that vary over time.
While this sounds unappealing at first, these loans typically start with a very low rate, attracting borrowers. Depending on market conditions, these rates can fluctuate up or down, changing the monthly payment.
This type of loan works best for those who know they can repay the loan quickly, avoiding extra months of unpredictable payment amounts.
Fixed-Rate Personal Loan
Interest rates play a large role in determining which personal loans are most popular. Most personal loans are fixed-rate, which means that the interest and monthly payments are consistent throughout your repayment.
This makes it easier for you to budget your monthly payments, ensuring your loan is repaid efficiently and on time. This also allows you to calculate your interest over the loan’s life which leaves little room for unpleasant surprises.
Consider Your Credit History
Your credit history and/or credit score is a reflection of your total debt, lines of credit, and payment history. Think of it as your financial transcript, given to higher financial institutions to accept or deny your access to things like loans and financial accounts.
The better your credit, the more lender options you can choose from. This gives you the chance to find lower interest rates, potentially saving you up to thousands of dollars. Better credit also opens the door to more personal loan options, such as the unsecured personal loan described above.
It’s important to remember that your credit history not only affects your personal loan but vice versa. Paying back your personal loan is essential to maintain or even raise your current credit score, and future lenders will be able to see if and how you repay this loan on your credit history.
If your credit score is good or excellent, happy personal loan hunting! If it’s below average, we recommend taking some time to work on it to better your financial future. You can better your credit score by paying your current dues on time and limiting your credit card use.
Personal Loan Interest Rates
One of the biggest factors to consider before taking out a personal loan is the interest rate the lender offers. Interest rates are essentially the fee you’re paying on what you owe. They are included in your monthly payments and vary depending on the loan and amount.
Small differences in interest rates make big differences in how much you will pay by the end of your loan.
Take this example: A personal loan of $25,000 over 5 years at 6% interest will have you pay around $4,000 in interest by the end of your loan. That same loan and timeframe with a 6% interest rate will charge you around $5,400 in interest. That’s over a $1000 difference per one percent of interest rate!
These numbers could be much higher depending on the amount and time frame of the personal loan. Use a free loan interest calculator to know what you will be paying in interest before confirming the personal loan, and only take it out if you can afford the repayments, interest included.
Personal Loan Fees
The interest rate and your loan repayment are not the only charges your lender may include in their personal loan. Look out for and ask about things like a processing fee, which is completed while applying for certain loans. Some of these are non-refundable, even if you are denied the loan, so make sure to read the fine print.
Another possible fee is the prepayment fee. This is incurred when a borrower chooses to pay off the loan before the agreed-upon date.
Finally, there are also late payment fees which are only incurred should you fail to make your monthly payment by the due date.
Paying Back a Personal Loan
Other important factors to consider before taking out a personal loan are the details surrounding your repayment of the loan.
First, take a look at all of your current monthly bills and accumulated debt. Calculate the income you have leftover at the end of the month. This will determine your maximum possible monthly payment to repay a personal loan in the future.
Make sure this limit doesn’t leave you at a balance of $0, as other emergencies may always arise. Account for possible changes in your income, such as unpaid holidays or vacation days.
Once you know how much you can afford to pay back per month, determine how long you are willing to do so. Repaying a loan affects both your credit score and your overall financial health.
Do you expect any other future expenses which may get in the way of your monthly payments? Have you accounted for accrued interest and fees? Remember that some personal loans charge a fee if you plan to pay off the loan early.
Set your boundaries and only take out a personal loan that respects them.
Alternatives to Personal Loans
Perhaps you hope to work on your credit history and do not need to take out a personal loan at this time. While taking out a personal loan is always an option, there are other alternatives in the meantime.
If the situation is not urgent, saving up money is the safest way to make a purchase. This avoids taking on any more debt, thus not affecting your credit score negatively. You’ll be able to focus on your current bills and move forward with a financial goal in mind.
To do this, ensure you have a budget and stick to it. The final purchase will be that much sweeter when you are paying it cash in hand.
If you need to make a smaller purchase and don’t have the money upfront, a credit card may be a good alternative. While interest rates are higher than personal loans, you can pay back this smaller amount faster during your next billing cycle with fewer fees. There’s a bit more flexibility than with personal loans, but the borrower should be wary of accumulating too much credit card debt.
For those with low credit scores or dismal credit histories, payday loans abound. These are a quick way to get cash in hand with typically easy application processes.
While it may seem appealing, payday loans often come with high-soaring fees which can leave people trapped in repayment. Make sure to inquire about all fees and total costs before considering a payday loan.
Lines of Credit
With lines of credit, you have a limit out of which you can withdraw money. You pay interest on the money borrowed, similar to a credit card structure.
Personal lines of credit are similar to unsecured loans, while other types of loans may resemble secured loans. One example of this is a home equity line of credit which uses your house as the collateral asset.
There are many factors to consider before taking out a personal loan. First, it’s important to decide if the reasons for your loans are urgent and necessary, or if they can wait. If the emergency warrants the loan, you’ll have to understand which loans are available and which you qualify for.
Once you narrow down the type of personal loan you would like, it’s time to compare lenders, paying special attention to interest rates and fees. Finally, remember to prioritize the repayment of your loan to avoid financial mishaps in the future.
A personal loan is a great way to face financial emergencies when you need cash fast. When used responsibly, they can be a lifesaving force in the face of a financial storm.