Sometimes you need extra cash to help pay off debt, fund a wedding, bankroll a much-needed bathroom renovation or take care of another financial need or goal.
Some consumers may tap credit cards, home equity loans or even ask a relative for financial help. But others may opt for a personal loan, typically available at a set interest rate over a defined repayment period and lent out by financial institutions such as banks, credit unions and even some financial startups.
If you're considering tapping this kind of financial product, here's what to know about taking on a personal loan.
What Is a Personal Loan?
A personal loan is "a generic all-purpose loan, for a fixed term, a fixed number of payments and at a fixed rate," says Chris Dervan, head of the personal lending team at PNC Bank.
These debt products are typically unsecured, meaning they're not attached to any asset. So if you fail to repay, you won't have your car, house or another belonging repossessed. That may translate to a higher interest rate on the loan, and don't forget that neglecting to pay your bills can wreak havoc on your credit health and bring about calls from debt collectors.
What Are Good Reasons to Take Out a Personal Loan?
There are myriad viable reasons to consider tapping a personal loan. "There's an awareness among customers (that) it really can be used for a variety of purposes that can't be financed easily through other means," Dervan says. Those purposes may include funding a wedding, home improvement or consolidating separate pre-existing debt into a single monthly payment.
"One of the big advantages is that it's predictable," says Gerri Detweiler, education director for Nav, a San Mateo, California-based service that matches small business owners with financing options. You'll often know your interest rate, monthly payments and length of repayment, which could be one, two, three or five years.
There's also a credit score benefit to borrowing a personal loan instead of, say, accruing credit card debt. Since these are installment loans, they are reported under a separate category on your credit report and can have a more favorable impact than taking on a lot of credit card debt, Detweiler says. "If the choice is between maxing out the credit card and getting a personal loan, if the goal is to protect your personal credit, the personal loan could be a better choice," she says.
How Can I Qualify for a Personal Loan?
You'll typically need to apply for a loan online or in a brick-and-mortar financial institution, such as a bank or credit union. Rate-tracking sites, such as Bankrate and MyBankTracker, publish current interest rates and offerings from a range of creditors. "There are a wide variety of lenders who will extend credit to borrowers across the credit spectrum," Dervan says. Typically, the better your credit score, the better rate you'll get.
You'll need to submit an application with information on who you are, your financial status and credit health. You may also need to show pay stubs, bank statements and employment verification to prove you can repay the debt, says Jason Reposa, CEO and co-founder of MyBankTracker. The lender will use that data to determine whether you are a relatively safe credit risk. The creditor may ask what the loan will be used for when considering your application.
Alternatives to Personal Loans
If you're considering a personal loan, keep in mind that there are competing products on the market that may work better for your situation or carry a lower interest rate.
"Home equity is a big one," Reposa says. When you tap home equity through a loan or home equity line of credit, you borrow against your home's value. This kind of debt can be cheaper because it is secured by your house.
An alternative for debt consolidation is the savvy use of credit card introductory rates to transfer high-interest credit balances to a new card and repay before interest starts accruing. Before using this strategy, weigh the fees charged for a balance transfer against those charged by a personal loan.
Borrowing against your 401(k) is another option for tapping cash, but it has its own downsides and risks, including the fact that your savings won't be able to grow in the market while you repay the money.
For specific kinds of purchases, such as for an automobile, eligible educational program or new home, there are dedicated products, such as student loans and auto loans, which are always worth considering.
Keep in mind, too, that if you have a relative or friend who is willing to set up a loan contract with you, tapping that resource can be a viable alternative. This is one to approach carefully, Reposa says, because it can have an impact on family dynamics.
Fees to Watch Out for With Personal Loans
You'll pay interest on the personal loan, with rates currently ranging from 5.25 percent to nearly 36 percent, according to loans listed on MyBankTracker. The rate you pay may depend on your credit score, location and other financial information. "In most cases, (interest is) going to be compounded daily," Reposa says. "It's going to be accruing from the day you have that money transferred into your account."
Personal loan companies may also charge a loan origination fee to process the loan, at anywhere from 1 percent to 8 percent, which will increase the debt's overall cost. It's also worth noting whether there's a prepayment fee for repaying your loan early.
Reposa recommends asking about pre-compounded or pre-computed interest, meaning that interest payments are front-loaded and reverse slowly as you continue to repay the loan. This essentially reduces the benefit of paying early or in excess of the set monthly bill. "That's another way lenders protect themselves against prepayment," Reposa says. "In those cases, you're getting a higher interest rate."
Should I Get a Personal Loan?
If you are able to repay the loan and can confirm that the fees and interest rates are reasonable, the alternatives are no better, and you can't pay the expense out of pocket, then a personal loan can be a legitimate option, experts say.
Just make sure that you do your research ahead of time and understand the repayment terms and schedule before signing onto this financial product. "The way we look at a personal loan is it's a temporary thing," Reposa says. "This money has to be repaid."
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