Maybe you’re in the midst of an emergency and need cash fast. Or, you’re looking to make some home repairs or make a large purchase. Maybe you want to consolidate your debt, or just start building credit.
All of these are common reasons people look into getting a personal loan.
A personal loan is an unsecured (meaning you don’t have to put up collateral), installment-based loan. These types of loans often have lower rates than credit cards but may have higher rates than car loans.
While personal loans are quite helpful at getting you money when you need it, it’s important to know what you are signing up for.
Basics of Loans
Principal is the amount you are borrowing. Interest is the cost to borrow money, and it’s set as a percentage. And the term is the length of time you have to borrow the money. The term affects the minimum monthly payment amount and the total cost you’ll pay in interest.
Paying Back the Principal of a Personal Loan
Like mortgages and vehicle loans, a personal loan will give you a one-time fixed amount.
This is different from credit cards and a Home Equity Line of Credit (HELOC), which both involve revolving credit, so you can keep withdrawing money as you need it.
For example:
- When you apply for a personal loan, you’re applying for a specific amount, such as $5,000 or $50,000, which you receive all at once. The lender (the entity that gave you the loan) will start charging you interest on the full amount.
- With credit cards and HELOCs, you receive a credit up to a certain amount and you can borrow in smaller increments up to that total. So, if you have a credit limit of $15,000, you can make a purchase of $50 and then $500, and the lender will only charge you interest on those purchases (totaling $550) and not the limit of $15,000.
When it comes to paying off your personal loan, most lenders make sure to collect the interest charge before the principal. So, if the lender charges you $85 in a single month and your minimum monthly payment is $215, then only $130 of your payment went toward the principal total.
If you pay more than the monthly minimum amount, then that additional sum goes directly to the principal.
Since personal loans are not revolving credit lines and you receive the full amount upfront, you can see how much you have left to pay on your principal amount on each statement.
Why Personal Loan Term Lengths Matter
Credit cards do not have terms. As long as you pay the monthly minimum, you can take as long as you want to pay back the principal. A credit card’s monthly minimum payment is typically 1 to 3% of the statement balance or a flat fee plus interest. As a result, however, you end up paying a lot in interest fees, which can be very costly.
Personal loans, on the other hand, have terms, so the monthly minimum amount is one that has you pay off the principal plus interest by the end of the term.
Here are some examples of how term lengths and interest amounts affect how much you end up paying for a $10,000 loan:
- Five years at 10% interest equals a monthly payment of $212 and $2,748 in interest paid.
- 10 years at 10% interest equals a monthly payment of $132 and $5,858 in interest paid.
- Five years at 15% interest equals a monthly payment of $187 and $4,274 in interest paid.
Essentially, shorter rates mean higher monthly payments but less interest paid over the course of the term. And a smaller interest rate means a smaller monthly payment and less interest paid total.
Most short-term (less than 36 months) personal loans have fixed interest rates. Personal loans that have terms longer than five years may have a variable loan, which means that the interest rate can change over the course of the term. Having a fixed rate makes it easier to budget since there are no surprise changes.
Your Credit Score Influences the Personal Loan’s Interest Rate
Your financial history affects the interest rate a lender will offer you for a personal loan. Lenders typically give those with better histories lower rates, while giving those with poorer histories higher rates. That is because borrowers with histories of paying their bills on time, having low debt-to-income ratios, and income stabilities are less risky.
What factors can affect your interest rate:
- Credit score – If you have an excellent score (more than 720), lenders typically give you the lowest rate. A good score is between 690 and 719, and you may receive an average rate. If you have a fair score (between 630 and 689), lenders may offer the highest rates. And, unfortunately, a bad score (less than 629) may result in being denied for a loan.
- Payment history – As mentioned, a history of on-time payments to multiple creditors implies a lower risk than a history of missed or late payments.
- Debt-to-income ratio – While a positive history of on-time payments to multiple lenders looks good, too much debt compared to your income does not. A low ratio is less than 36%, meaning your monthly debt obligation is not more than about a third of your earnings.
- Length of credit history – A longer history gives lenders more information about how you pay your debts. A decade or longer of credit history is better than someone who has never handled debt before.
- Income and employment stability – Lenders want to know how you will pay them back. If you have steady wages and higher income, they see you as less of a risk than someone who has unreliable work and inconsistent earnings.
- Recent credit inquiries – Lenders don’t want your other newly acquired debts to infringe on your ability to pay the debt you owe them. So, if you are applying to multiple lenders, they may all deny your applications because they see each other as competition for repayment.
What to Watch Out for When It Comes to Personal Loans
One main difference between personal loans and other types of loans is in its name; personal. So, lenders may not ask questions about what you plan to use the money for. Personal loans can be helpful for covering the costs of multiple things, from surprise expenses to necessary costs.
However, this may not be a good thing if you plan to use the money foolishly. While paying for a car repair can help ensure you make it to work, you should reconsider using a personal loan for certain purchases, such as:
- Discretionary Purchases – We’d all love to go on lavish vacations, make luxury purchases, and have big, memorable moments, but a personal loan shouldn’t fund a lifestyle you can’t afford now or possibly ever.
- Daily Living Expenses – A personal loan is not a long-term solution to cover your rent, groceries, and utilities. Your income should pay for essentials without a new repayment obligation.
- College Tuition – If you need money for college, apply for a student loan. Student loans have far more benefits than personal loans, including lower rates, flexible repayment plans, and even loan forgiveness.
- Investing or Gambling – Borrowing money to cover speculative investments or betting is very risky. Some lenders even have rules against using funds for these reasons.
Generally, you shouldn’t apply for a personal loan if you can’t afford the payments, you are already in deep debt (unless, perhaps, to consolidate debt), or if you have poor credit (since you would likely get a high interest rate).
