September 16, 2020
By Rahul Iyer
Credit comes in many forms, mortgages, credit cards, and personal loans. Here we're going to look at the ins and outs of personal loans so you can gain a better understanding of what a personal loan is, and the situations in which someone might take out a personal loan.
Personal loans, sometimes called signature loans or unsecured loans, are when you borrow money from a bank, credit union, or other lenders, that you pay back over time. They are often called unsecured loans because they are not backed by collateral, meaning they are approved without property or other assets. Most personal loans fall into this category and are instead approved based on creditworthiness (your credit score).
You will be approved for a personal loan based on your credit score and other factors such as your credit report and your debt to income ratio. For example, if your credit report shows that you have opened a high number of credit accounts in a short period, even if they only account for a small amount of debt, this might be concerning to the lender. If you have a lot of debt and a low income, this is also concerning because it makes the lender less confident that you will be able to make the repayments.
Here is some of the terminology you will come across when looking for personal loans:
Principal - This is the amount of money you borrow. For example, if you apply for a $5000 loan, then your principal is $5000. The amount of interest you pay will be dependent on your principal.
Interest - This is the money you pay in addition to repayment and is typically thought of as a "fee" for getting access to the money upfront. This is usually expressed as a percentage.
APR - This stands for Annual Percentage Rate. The APR is the interest rate plus any additional lender fees, helping to give you a clearer picture of your monthly repayment costs. APR can vary greatly depending on your credit history, ranging from 6% to 36%.
Personal loans are primarily used to consolidate high-interest debts or to make a big purchase. Here are some of the ways personal loans are commonly used:
Consolidating Credit Cards
If you have several maxed-out credit cards with high APRs, then it might be a good idea to get a personal loan to consolidate your debt into one monthly payment. The interest rate on the loan may also be lower than the APRs on your credit cards, which can help you get back on track.
Refinancing Student Loans
You might be able to get a personal loan with a lower interest rate than your existing student loans, thereby helping clear your debt faster. However, this isn't always the best idea because student loans often come with tax advantages and federal benefits not available with personal loans.
Funding a Big Purchase
For example, a wedding, home improvements, or buying a car. This might be a good idea if you are going to use credit anyway and prefer a loan over credit cards. However, whether it’s a good decision will likely come down to your current financial situation and whether you want or need the purchase.