Understanding what is a personal loan will enable us to maximize the product to its full potential. As you know, a personal loan is one of the commonly used, needless to say, the most accessible form of loan for everyone.
Based on a report published by CNBC, the unsecured personal loan market in the United States hit an all-time high in 2019. It surged to “17 percent year over year to $138 billion, according to data from TransUnion“. In the same report, it stated that the digital-first financial technology or fintech companies are the primary drivers for the said increase, making personal loans available for everyone. Needless to say, making it easily accessible with just a click on their smartphones.
Furthermore, in data from the Chamber of Commerce, it says that the current total personal loan debt in the country has amounted to $143 billion, and just the same, fintech companies are to blame for the increased number. In fact, by Q4 2018, “fintech loans accounted for 38% of outstanding loan balances, compared to a mere 5% five years prior.
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But apart from the existence of fintech companies, which, according to Investopedia, refers to “the integration of technology into offerings by financial services companies in order to improve their use and delivery to consumers,” another major reason for the increase of personal loans in the country is the fact that personal loans can be used for almost anything.
You can use it for both necessity and leisure, for emergency purposes, or for something that you have been planning to purchase for a while now.
But what is a personal loan really?
While some of us may be knowledgeable about this very popular form of a loan, others have very little knowledge about, and that is precisely why we are going to share with you everything that you need to know about – personal loans.
To be specific, we are going to tackle the following essential information about personal loans:
- What is a personal loan?
- How does a personal loan work?
- What are the different types of personal loans?
- Who is eligible to apply for a personal loan?
- How to get approved for personal loans?
- What can a personal loan be used for?
- Where to apply for a personal loan from?
WHAT IS A PERSONAL LOAN?
If you will search over the internet what is a personal loan over, you will find hundreds if not thousands of (mostly finance-related) sites with their own version of definition about the term. But, if you will examine each definition, they all basically mean one thing — it refers to the money borrowed from a lender, which could be a bank, a credit union, or an online lender.
The amount of money borrowed will be repaid with a corresponding interest, which could either be fixed-rate or variable-rate (we will discuss these terms further later on).
Generally, the interest rates on personal loans depend from one borrower to another, taking a lot into consideration the borrower’s credit.
Personal loans are installment loans, which means, you can pay it for a specific period of time depending on what you have agreed upon. It could be within x number of months or in some cases (especially when the loaned money is big), lenders allow x number of years to have it repaid. To put it simply, the money is issued right there and then, and the borrower has to repay the loan with a fixed payment over a predetermined loan period.
One more personal loan feature that makes it stand out from other forms of loans is that most personal loans are unsecured loans. This means that you do not need to provide any collateral to the lender.
However, unlike secured loans, the average interest rates on personal loans tend to be higher, but still lower as compared to credit card interest rates.
Before moving on, here’s a quick video by Keder Cormier wherein he discusses what personal loan is all about. It’s very informative, you should check it out by clicking the play button below:
HOW DOES A PERSONAL LOAN WORK?
Now that you already know what is a personal loan, this time we will discuss how exactly does it work.
We find it necessary that before you even get yourself into borrowing money through personal loans, you should make time to fully understand how it actually works. This will help spare yourself from confusion and making wrong moves or decisions with regards to personal loans.
So, as mentioned earlier, a personal loan is a type of installment loans like mortgage and auto loans. That means you borrow a certain amount of money, and then, you pay it back with an interest in monthly installments over a specific period, which usually ranges from 12 to 84 months.
Once you are done paying off the loan, your account will be automatically closed. Should you need more money, all you have to do is apply for a new loan. That’s basically how a personal loan cycle goes.
However, it is important to take note that the details vary from one lender to another, which is why it is important that you do your research first before you jump into sending a personal loan application to a financial institution.
There are three major details that you need to look into. These are:
- Interest Rates
- Repayment Period
- Origination Fees
So, what are these all about? Read on.
Interest Rates
Earlier, we mentioned about fixed rates and variable rates. It’s time for you to fully understand what these terms are all about.
But first, know that interest rates vary from one borrower to another depending on the person’s credit. The better your credit is, the lower your interest will be. Otherwise, if you have thin or bad credit, expect to get a higher interest rate. Some of which may be as high as credit card rates, and in some cases, lenders may require you to have a co-signer for the loan.
Now, what is a fixed-rate, and what is a variable rate?
- Fixed-rate is the most common type of interest rate among lenders. This basically means the interest rate does not fluctuate during the entire period of the loans. You basically make the same amount of monthly payment from day one of the loan periods. This allows borrowers to accurately predict their monthly payments.
- Variable-rate, meanwhile, is not that popular, but it’s there. Basically, the interest rate charged on the outstanding balance depends on the market interest rates change. Thus, as a result, you may end up paying more or less.
So, as you can see, between the two, fixed-rate interest is the most ideal. No wonder why it is widely used by lenders as compared to variable-rate interest.
Repayment Period
Apart from the interest rate, another important thing that you need to look into is a personal loan’s repayment period or repayment time.
All lenders have their respective repayment periods depending on the amount of money borrowed or in other cases, on the borrower’s ability to pay off the debt.
Repayments vary — normally, 12, 24, 36, 48, or even as long as 84 months. While longer payment periods seem to be more convenient because it means lower monthly payments, this, however, also means you are going to pay more in interest.
Meanwhile, a shorter payment period, while it means higher monthly payments, results in lower interest rates.
It is also important to note that having an open loan or existing loan can affect your ability to get approved for other loans, or even for availing credit cards. This means, if you pay for a loan longer, you have to be open to face the consequences, which limits your ability in obtaining new credit.
Also, a lot of personal loans come with penalties for paying off the debt early, which is why between long-term and short-term loan periods, it’s best to take the shortest repayment period that you can afford.
Origination Fees
Origination fee refers to a fee a borrower needs to pay to his or her lender upon receipt of funds. Basically, the fee compensates the lender for expenses such as processing your application, as well as marketing.
Normally, the origination fee ranges from 1% up to 8% of the total amount borrowed. Although in some cases, there are lenders that charge a flat origination fee, while others do not charge anything at all. Again, it varies from lender to lender, which is why comparing lenders before you seal a deal is ideal.
The origination fee is only charged if the loan is approved and funded. So, if your personal loan application is denied, you should not be paying any origination fee.
Generally, lenders deduct the origination fee from the total approved loan amount. So, for instance, your personal loan amounts to $8,000. The lender charges a 2% origination fee, which in this case amounts to $160. Thus, instead of receiving the full $8,000 loaned amount, the borrower will receive $7,840 (origination fee is already deducted).
To be specific, the origination fee is charged to cover upfront costs such as the following:
- Income verification with national databases
- Credit checking with credit bureaus or other alternative sources
- Reviewing your application
To put it simply, the origination fee may be determined based on the loan amount, the repayment period, the borrower’s credit history, as well as whether or not there’s a co-signer required, and the reason for the personal loan.
WHAT ARE THE DIFFERENT TYPES OF PERSONAL LOANS?
Part of understanding what is a personal loan is knowing and understanding also the different types of personal loans.
There are two types of personal loans. These are secured loans and unsecured loans.
What are these and what sets each other apart from one another?
Here’s a quick definition of the two:
Secured Loans
This refers to the type of personal loan that is backed by collateral like a certificate of deposit or a savings account. Basically, if the borrower is not able to make payments for the loaned amount, the lender has the right to claim the borrower’s asset as payment for the loan instead. Since the collateral reduces the lender’s risk, it’s normally easier to qualify for this type of loan. More so, lenders offer more favorable terms.
Unsecured Loans
Unsecured loans, meanwhile, refers to a type of personal loan that is not backed by collateral. Generally, lenders that provide or offer unsecured personal loans base whether the borrower qualifies or not for a loan on his or her financial history. However, the downside of unsecured loans is that they tend to have higher interest rates as compared to secured loans.
To be honest, it’s hard to say that secured loans are better than unsecured loans, or vice versa, because obviously, it depends on a number of reasons like if the borrower wants lower interest rate or if the borrower does have an asset that he or she can pledge as collateral.
It’s safe to say that determining which is better between the two will depend on the borrower. So, yeah, it all depends on you.
WHO IS ELIGIBLE TO APPLY FOR A PERSONAL LOAN?
By this time, you already know what is a personal loan, how it works, and the two types of personal loans. Now, it’s about knowing who is eligible to apply for a personal loan.
Generally speaking, a borrower’s eligibility for a personal loan depends from one lender to another. Each lender has their own set of requirements specified for personal loan applicants. Some of the common requirements include:
- Must be a U.S. citizen or U.S. resident cardholder
- Must be 18 years old and above
- Must have a valid U.S. bank account
- Employment details
- Your monthly/annual income
- Proof of identification
Furthermore, a borrower’s eligibility, as well as the interest rate he or she is quoted, will be based on two major factors, which are your credit score, as well as your debt-to-income ratio. We’ll discuss this further because these two are very important. These are the make it or break it factors of your personal loan application.
Credit Score
Every personal loan lender has the freedom to their own credit score requirements.
However, according to Fair Isaac Corporation (FICO), which is a company that offers a credit-risk model with a score, and over 670 credit score is considered as “Good,” while more than 740 credit score is “Very Good,” and 800 and more is considered as “Excellent”.
Unfortunately, while those borrowers with 670 and below credit score or no credit score may still qualify for a personal loan, they may either find it hard to get approval or get one but with a higher interest rate.
In some cases, though, creditors or lenders allow borrowers with low credit scores provided they have a credit-worthy co-signer, or they have an asset that they can use as collateral to their loan (this one will fall under secured loans though).
Just to give you an idea, personal loan borrowers with great credit scores may qualify for an interest rate under 5%, while those who are less-qualified or with low credit scores may get approval with an APR of over 30%.
You see, the difference is quite huge.
Debt-to-Income Ratio
Borrowers’ will find your debt-to-income or DTI ratio by simply dividing their total monthly debt payments by their monthly income.
For instance, if you spend $500 to debt repayment monthly, and you have an income of $2,500 a month, your DTI is 20%.
According to one of the major banks in the country, Wells Fargo, you are “looking good” if you have a DTI that is below 35% a month. Meanwhile, borrowers with a DTI of 36% up to 39% are put under the “Opportunity to Improve” category. Those who have over 50% DTI need to “Take Action” because they are likely to have very limited options.
HOW TO GET APPROVED FOR A PERSONAL LOAN?
In relation to the qualifications we mentioned earlier, we are going to share with you some secrets, rather essentials, to ensure your personal loan application’s approval.
As we mentioned earlier, the approval of personal loans varies from one lender to another. More so, the requirements also vary. However, the process is quite the same.
Lenders evaluate personal loan applications according to the person’s creditworthiness. Typically, this means lenders review the borrower’s borrowing history, as well as his or her income.
There are three major aspects that you need to work on if you want to get your personal loan application approved. These are:
- Credit Score
- Income
- Collateral
Of course, we are going to discuss further each item for you to fully understand their importance.
Credit Score
It’s probably safe to say that checking the borrower’s credit score is mandatory among lenders. Lenders obtain a credit score to see whether or not you have already borrowed in the past.
Basically, a borrower’s credit report contains details about past loans, as well as late payments, and other public records that lenders might want to know.
In other cases though, lenders use “alternative” credit scoring tools like taking your history on-time rent as well as utility payments. These serve as their predictor of how you are going to repay a loan.
Income
Yes, how much you earn matters as well when applying for personal loans. By knowing the borrower’s income, lenders get to determine whether or not the borrower does have the capacity to pay off the loan.
Lenders may ask details about your income, as well as your employment.
Furthermore, knowing your income will help lenders calculate your debt-to-income ratio to ensure that the loan payment will not consume too much of the borrower’s monthly income.
Collateral
Just to reiterate, collateral is only necessary if you are applying for a secured loan. Unsecured loans do not require such.
The term collateral refers to any asset (a property, a savings account, etc.) that a lender accepts to secure a loan. If the borrower is unable to make payments for the loan, the lender may take the collateral to serve as a payment for the loan instead.
WHAT CAN A PERSONAL LOAN BE USED FOR?
By now, you have probably understood so much about what is a personal loan. But apart from what we have already discussed, it is also important that you know in what particular circumstance you can use a personal loan.
Generally speaking, you can use a personal loan for almost anything and everything under the sun. Unlike other types of loans, a personal loan covers almost any probable reason that you will need extra money.
But to be more specific, here are some of the common reasons where personal loans are used for:
Debt Consolidation
Some of us tend to have overflowing debts, and sometimes it gets to a point when it’s already too much to handle. And before you even think about just running away, one thing you can do to get away with so many debts is to consolidate them — especially if your current creditors are charging you a higher interest rate.
You can use a personal loan to consolidate old debts in just one lower rate. This will definitely work to your advantage. More so if the lender does not charge an origination fee.
Here’s the thing, once you have decided to consolidate your loans, make sure to pay off the current personal loan first. Consolidating loans can be quite tempting, but with determination and discipline, you will surely avoid getting into the same situation over again.
Student Debt
Some people use a personal loan to pay off existing student debt, although, to be honest, sometimes it’s not really a wise idea. It’s because the student loan interest rate is typically lower as compared to other types of loans — including a personal loan.
However, when you are left with no other choice, you can always opt to apply for a personal loan. Just make sure though that you are dealing with a lender that provides the lowest possible interest rate.
Medical Bills
Emergency happens, and oftentimes, it happens when we least expect it, and worse, when we are not financially ready for it. Good thing is, personal loans can help you when medical bills are beyond what you can afford.
However, before anything else, make sure to negotiate the bills first. Some healthcare providers may be able to give you a discount, which will surely help lessen the financial requirement. Another thing is to ask the healthcare provider if you can pay off the medical bills in installment. But as they say, when all else fails, a personal loan may be what you really need to pay off the bills.
Small Home Improvements
You know, sometimes we tend to find ourselves wanting some change in our homes, but we cannot pursue it because of the lack of budget. But guess what? Personal loans can also be used for home improvement purposes!
While it is more popular to use home equity loans for home improvement projects, some people would prefer using a personal loan instead especially if you do not really need a significant amount of money.
A personal loan intended for home improvements could actually be less expensive. Needless to say, it’s easier to apply for.
Expensive Purchases
There are times when we want to buy something but couldn’t because we are financially incapable or simply because we do not have cash. The thing is, a personal loan actually lets you use the money for whatever purchases especially expensive ones of course. Don’t worry you won’t be judged.
But of course, it is always best to make sure that you are only spending money rather than borrowing money for worthy purchases. Worthy meaning something that you genuinely need, and not just because you want that item for yourself.
Travel or Vacation
Dreaming for a fabulous vacation? You surely can do that! And yes, you can apply for a personal loan for that purpose.
Ideally, you should save up for your dream travel or vacation. However, there are instances when you need to go to a place, and saving up would cause a delay. Thus, a personal loan might just be a great idea for you.
Car Financing
Some people prefer personal loans over car loans because car loans are secured loans, which means the car you bought automatically becomes collateral. So, in case of failed payments, your dream car will be repossessed by the lender.
More so, personal loans do not require a downpayment, while auto loans usually do. So, unless you score a low-rate auto loan, a personal loan would be more ideal to buy yourself a new car.
Small Business
Technically, a personal loan is not designed for business purposes. However, there are entrepreneurs especially small ones who prefer using a personal loan in funding their business’s launching or operating costs. Also, some online entrepreneurs who need small capital would rather use a personal loan over a more appropriate loan product.
Wedding Cost
Ideally, when getting married, you use your savings to fund this life-changing event. However, in some couples, this is not the case. Thus, the option to apply for a personal loan to help get through their desired or dream wedding.
Let’s face it, even the simplest wedding possible still need a penny to push through. So, when you really have to, when you have already pulled out all your resources but still not enough, a personal loan may be ideal for you. Just make sure though you only borrow what you need and not too much. After all, you do not want to spend the first few years of your married life paying off debts, right?
The list is actually long. There are just too many possible reasons to get a personal loan. As we have said earlier, unlike other types of loans out there, a personal loan can be used for almost if not everything. So, yeah, it’s safe to say that a personal loan is handy. You can borrow or apply for it anytime you badly need cash.
WHERE TO APPLY FOR A PERSONAL LOAN FROM?
So, you know now what is a personal loan. You also know already about the different types of personal loans, as well as who’s eligible, and for what purpose can you apply for such loan type. This time around, we are going to share with you where exactly to apply for a personal loan.
There are actually three different entities where you can apply for a personal loan. These are through:
- Banks
- Credit Unions
- Online Lenders or Creditors
Let’s discuss each further –
Banks
Banks are very accessible. In almost every corner especially if you are living in the downtown area, you will see a bank. Some of these have been around for decades, while others are relatively new in the banking industry.
Nevertheless, they all have one thing in common. They do offer personal loans to their customers.
The thing about traditional banks is that loaning or borrowing money requires the borrower to show up at the branch of the bank. He or she needs to apply for a personal loan in person.
As compared to credit unions and online lenders, banks are stricter when it comes to requirements. They do not easily approve a loan application — unless you qualify.
One major draw of banks, as we have mentioned earlier is the fact that they are all over the place. You can choose from a wide selection of banks in your area.
More so, applying in person allows borrowers to take advantage of benefits like asking help from a credit specialist to recommend the best possible loan offer. At the same time, borrowers may also request to have them go through the whole process.
In addition to that, the delivery process tends to be quicker as well especially if the borrower does have existing savings or checking accounts with the bank already.
Meanwhile, although traditional banking service is the key to applying for a personal loan in banks, with the technological advancement around, most banks have already jumped into offering online loan application as well. Definitely, this makes the process easier and more convenient.
- Requirements:
Requirements vary from one bank to another. However, most major banking institutions require a fairly minimum credit score of 660 to get approved for a personal loan application. With that said, banks are not ideal for those who have low credit scores.
- Interest Rate:
Interest rates also vary from bank to bank. Usually, though, banks charge at least 6%, and at most 25%.
Some of the best banks that offer personal loans are:
- American Express
- Citibank
- KeyBank
- Wells Fargo
- U.S. Bank
- Discover Bank
- TD Bank
- PNC
- Fifth Third Bank
Credit Unions
Between the three options on where to get a personal loan from, credit unions are probably the best choice.
First off, a credit union is a not-for-profit organization. It is a member-owned financial cooperative. To be able to get a personal loan, you have to be a member first, and because you are a member of the organization, that means you are part-owner of it.
The thing we like about credit unions is that it provides its members with a variety of financial services, which include credit with competitive rates.
Unlike banks, credit unions are not that popular. They are not as many as banks. That is why when you are opting to loan from a credit union, it is best to check first if you have one in your area.
Just like banks, though, you have to apply for a personal loan in person. Digital application is not a popular practice among credit unions, but who knows, maybe one of these days, they eventually offer it as well.
- Requirements:
Requirements for a personal loan application vary depending on the credit union. However, one thing is for sure, you have to be a member. Otherwise, you won’t be qualified at all.
With regards to credit score requirements, since credit unions are more community-oriented, they are more likely to approve loans even with people who do not have good credit.
- Interest Rate:
One of the best things about credit unions is that they offer lower interest rates compared to banks. This becomes possible because of the fact that federal credit unions have an interest rate cap set by a national board. Meanwhile, state credit unions have a cap set by the state government. At most, credit unions charge up to 18% interest rate only.
Some of the best credit unions that offer personal loans are:
- Affinity Federal Credit Union
- Aspire Federal Credit Union
- Georgia’s Own Credit Union
- Pentagon Federal Credit Union
- NASA Federal Credit Union
Online Lenders or Creditors
Obviously, online lenders refer to creditors who operate entirely online. This industry has grown over the years perhaps because of convenience, and the fact that online lenders offer competitive rates as well.
One of the major draws of online lenders is that you do not have to wait long for approval. In just a few minutes after an online loan application, a decision is given. Also, funds are provided as soon as approved.
Online lenders are ideal for people who are always on-the-go or those who badly need funds as soon as possible.
- Requirements:
Online lenders do have their respective sets of requirements. Unlike banks and credit unions though, online creditors lend to people with bad or have no credit at all.
- Interest Rate:
Compared to banks and credit unions, online lenders tend to have a higher interest rate (depends on your credit). In fact, some online lenders may charge as high as 36%, while some, as low as 6% interest rate.
Some of the best online lenders that offer personal loans are:
- FreedomPlus
- Marcus by Goldman Sachs
- SoFi
- LendingClub
- LendingPoint
FINAL THOUGHTS ON WHAT IS A PERSONAL LOAN
Perhaps by this time you have fully understood what a personal loan is all about. As you can see, there are so many things that you need to know before jumping into a decision of getting a personal loan on a financial institution.
As borrowers, we thought it is our responsibility to be fully informed to avoid making uninformed decisions or committing mistakes especially when it comes to money. After all, nobody wants to waste money, right? All the more if it is hard-earned.
So, do you see yourself applying for a personal loan anytime soon?