A personal loan is an unsecured type of installment credit. You borrow money without putting up collateral, which you then pay back with fixed monthly payments over a set time. You qualify for personal loans based on your credit score and can use the funds for a range of purposes.

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Personal loan rates and terms

Amount: $1,000 – $50,000
Term: 12 to 60 months
Cost: Loan origination fee (1-5% of the amount borrowed)
Interest Rate: 10-28%[1]

Personal loan APR can vary widely based on your credit score. If your credit score is bad, the rates can be as high as the rates on credit cards.

Credit ScoreInterest Rate Ranges
Excellent (720 – 850)10.3% – 12.5%
Good (680 – 719)13.5% – 15.5%
Average (640 – 679)17.8% – 19.9%
Poor (300 – 639)28.5% – 32.0%

Fees to avoid

Almost any personal loan will have an origination fee, which covers the underwriting and administrative costs of the loan.

It’s also fairly standard that you will face a late fee if you do not make the payment by the due date.

However, some personal loans have additional fees listed in the terms of the agreement. Early repayment or prepayment penalty fees get applied when you make an extra payment or larger payment than required.

You essentially get popped with extra fees for trying to eliminate the debt earlier than outlined in your contract.

These fees should be avoided, when possible. You always want to have the ability to repay debt quickly if your budget allows for it. You don’t want to face extra fees for doing that.

How do personal loans work?

Step 1: Before you apply

Prior to applying for a personal loan, you need to check your finances and define some goals. These loans can be a great option, but they can also create financial challenges when used in the wrong circumstances.

Ask yourself these questions

  1. What’s the purpose of the loan and how much money do you need to cover it?
  2. Is the need immediate or could you avoid taking out the loan by saving up to pay in cash?
  3. Will you be able to comfortably afford the loan payments?
  4. Do you have time to improve your credit to get a lower rate before you apply?

If you don’t know where your credit stands, it may be a good idea to check your reports before you apply. You can also check your score using a credit monitoring tool. That way, you’ll know what interest rate you can expect to pay.

It can also be helpful to use a loan calculator to assess the monthly payments you’ll need to cover. You can use the calculator to see how choosing a shorter or longer term will affect the payments.

Gather up the documentation you need

Anytime you apply for a loan, you will need documents proving who you are and how much income you have.

Making sure you have all the documentation you need will ensure that the application and underwriting process goes as quickly and smoothly as possible.

Step 2: Shopping for the right loan

The next step is to find the best loan and lender to fit your needs. You want to compare rates and terms from several different lenders before you apply for a loan. This means you need to get quotes from several different lenders.

It’s a good idea to start with your bank or credit union. Online loan comparison tools make it convenient to see loan offers from a range of lenders all at once.

They’ll ask for some basic personal information, your estimated credit score and what you need the funds for.

Based on this information you will receive a loan offer from each lender. Lenders will generally tell you the following in an offer:

  • how much you can borrow
  • an estimated interest rate or range of rates you can expect to pay
  • ways to reduce the interest rate, such as signing up for AutoPay
  • how quickly you can get approved

Tip: Be careful when shopping for loans that you do not start the application process with a lender. You only want to apply for one loan once you find one that seems to fit your needs. Applying for multiple loans at once can damage your credit score. Make sure to ask for quotes only.

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Step 3: Application and loan underwriting

When you find the right lender based on the offer you receive, you can apply for the loan. Now the lender will ask for more detailed information about you and the loan you want to take out.

Your application will be assigned to a loan underwriter. They will review all the information you provide to make sure you qualify for the loan. The underwriting process includes:

  • A credit check that you must authorize. This check will appear on your credit report.
  • Checking your debt-to-income ratio with the new loan payments included. This ensures you can afford the payments

If you qualify, the underwriter works with you to set the term of the loan, which determines your monthly payments. Once you have everything set, the underwriter will draft the loan agreement.

You must sign and return the agreement, at which point your loan becomes official.

Step 4: Disbursement and loan repayment

Once your loan agreement is signed and returned, the lender will disburse the funds.

In most cases, you receive the money from the loan with a lump-sum direct deposit into your bank account. Using direct deposit is beneficial, because it allows you to receive the money faster, usually within 1-2 business days.

Your loan payments will begin the month after you receive the funds. Make sure you know the due date of the new bill so you can pay the first installment promptly. Setting up AutoPay where the funds are debited from your bank account can be helpful.

You will make fixed monthly payments for the term of the loan that repay the principal (the amount you borrowed) plus interest. Making extra payments or larger payments can help minimize interest charges and the total cost of borrowing.

What can you finance with a loan?

The funds from a personal loan can be used to help achieve almost any financial need or goal.

  • Debt consolidation
  • Home improvement
  • Major repairs (home, HVAC, auto)
  • Medical expenses
  • Pregnancy and adoption costs
  • Veterinary expenses
  • Large purchases or expenses
  • Starting or funding a business venture
  • Investment seed money

You can use the funds for a combination of purposes. For example, let’s say you have a medical procedure that you need, but your insurance doesn’t cover it. You can get a personal loan to cover those expenses based on the estimate that you receive. Then you can use additional funds to pay off a few credit card balances.

Debt consolidation loans are really just an unsecured personal loan with a specific mission. – Howard Dvorkin, Chairman of Debt.com Click To Tweet

Rules for borrowing

An approval isn’t a guarantee you can afford a loan

Don’t take a loan approval as an affirmation that a loan is the best decision for your finances. While the loan underwriter will check your debt-to-income ratio, you may be just on the cusp of getting approved. If you’re already on a tight budget, a few unforeseen emergencies could drive you over the financial edge.

Always make sure you can comfortably afford the loan payments WITH extra breathing room in your budget.

No credit check usually means unfavorable lending terms

Debt consolidation with a traditional fixed-rate loan isn’t always possible if you have bad credit. But many short-term installment lenders will try and take advantage of your situation. They will offer you loans with extremely high interest rates, high finance charges and short repayment periods.

These are known payday loans, short-term installment loans, or cash advance loans. But whatever they’re called, they’re usually not good for the borrower. It’s best to avoid them. If you can’t consolidate with a traditional loan that offers a term of 12-60 months, don’t consolidate!

And always make sure that the interest rate on the loan is reasonable.

The debt problem created by payday loans surrounds the granting of multiple payday loans or rolling old loans into new ones. It does not break a cycle of debt but instead makes it worse. – Steve Rhode, The Get Out of Debt Guy Click To Tweet

You can get a lower rate, but you may risk too much

Secured loans, such as home equity loans, can also be used to consolidate debt. However, you should never borrow against your home solely for the purpose of paying off unsecured debt.

If you default on a credit card, you may be headed for civil court. If you default on a home equity loan, the lender can start foreclosure actions to take your home.

The same is true of title loans, where you put up the title to your car to borrow money. This is a recipe for repossession. It’s best to be avoided.

I get why people fall into these title loan situations. It’s typically someone who has bad credit, a regular lender won’t touch them, and they need cash straight away.” – Steve Rhode, The Get Out of Debt Guy Click To Tweet

Don’t damage your credit with multiple applications

With some types of loans, such as mortgages and auto loans, the credit bureaus will group multiple applications within a short timeframe. This allows you to compare the real rates and terms you’d qualify for to get the best loan possible.

You can apply for multiple loans, usually within a 45-day window and it will only count as one credit inquiry on your credit report.

However, this is not the case with unsecured personal loans, Each application will count as one inquiry on your credit report. Too many of these inquiries can hurt your credit score, meaning you might not qualify for as good of an interest rate.

When shopping for personal loans, always make sure to ask for a quote fro a lender. You can receive multiple quotes without hurting your credit. Then, when you think you find the loan that fits your needs, you should apply for it specifically.

Paying off a loan early shouldn’t cost you more

If possible, you want to avoid loans that penalize you for early repayment. Prepayment or early repayment penalty fees get tacked on when you attempt to pay off the loan faster than scheduled. That’s not in your best interest.

If you have the means to pay off a debt early, you should be able to do so without incurring extra fees. Most loans don’t include these types of fees, so you should avoid them whenever possible.

Pay off your loan as quickly as possible

Extending the term on a loan will lower the monthly payment requirement. However, it will increase the total cost of borrowing because the lender will have more months to apply interest charges.

Choosing a shorter term will increase the monthly payment, but help you save money over the life of the loan. It’s a good idea to choose the shortest term possible that you can comfortably afford within your budget. This will help you keep the cost of borrowing money low.

Loans and credit can’t be a substitute for income

Getting a personal loan won’t solve any challenges you’re having balancing your budget. If you’re slowly slipping deeper into debt because you don’t have savings to cover emergencies, a loan won’t help. In fact, you’ll likely end up with more debt that you need to pay off.

When calculating new loan payments into your budget, you should not budget down to the last penny. There should be savings built into your budget, usually about 5-10% of your income.
This cushion will allow you to cover emergencies, which will help you avoid adding more debt that you didn’t intend to add.

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If you have trouble getting approved…

There are two basic reasons you get rejected for a personal loan:

  1. You don’t have a strong enough credit score
  2. You don’t have enough income

Overcoming credit score challenges

The most common reason people get rejected for a loan is that they don’t have the credit necessary to qualify. You either have bad credit or you have a “thin credit history” – meaning you basically have no credit yet.

If this the reason that you don’t qualify, don’t run out and start looking for loans that don’t require a credit check. These loans will have extremely high interest rates and come with a high risk of creating financial hardship.

Instead, you need to take some time to build your credit. The exact method you use will depend on your score.

If you have bad credit…

Start by checking the credit utilization ratio on your credit card accounts. This is the ratio that measures the balance on the account versus the total available credit limit. Anything higher than 30% will hurt your score.

So, if you have credit cards sitting at 50% utilization or higher, that could be a big factor in why your score is low. Focus on paying off your existing credit card debt.

Making all your payments on time will also help you build a positive credit history. If you’ve missed payments in the past, that’s also hurting your score. Positive actions now will help offset those missteps.

If you have no credit…

If the lender simply says your credit file is simply too thin to qualify, there are a few things you can consider.

  • Credit builder loans are small personal loans that you take out specifically for the purpose of building credit. You make installment payments for 12-24 months and then receive the money you paid in back. It’s a great way to build your score while forcing yourself to save at the same time.
  • Secured credit cards are also designed to help people build credit. You put down a small cash deposit to open the credit line. Since that deposit secures the limit you get, you can qualify regardless of your credit score.

Overcoming income challenges

If you’re rejected for a loan based on your income, it’s usually for one of two reasons.

The first is obvious – you don’t make enough money to qualify. In this case, you may need to get a second job or seriously consider if you can afford to borrow. If you have an immediate need for cash, do whatever possible to avoid high-risk borrowing options such as payday loans. Consider if you can sell items for cash or borrow money from a friend or family member.

The second reason is a little more nuanced – you have income, but you already have too much debt for what you make. In this case, you may be able to solve your problem by paying off debt so you can afford to borrow again.

If you’re consolidating debt, consider alternatives

A debt consolidation loan is not the only solution for getting out of debt more efficiently. If you’re in a situation where you have a bad credit score or too much debt already to borrow, you have options. Instead of taking on new debt to get out of debt you already have, you may need professional help.

Your first step should be to get credit counseling. A certified credit counselor can help you evaluate your debts and budget to determine the best way for you to get out of debt. They may recommend:

Connect with a certified credit counselor to review your options.

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Article last modified on June 16, 2020. Published by Debt.com, LLC

contributors

Howard Dvorkin, CPA

CPA and Chairman

Steve Rhode

Expert contributor