Of course, they can be used to finance many other things like starting or growing a business, home repairs, etc. However, when it comes to leveraging personal loans, as with all debt, it's important to understand how it works and the associated risks. It's also important to be mindful of how you leverage debt.
What is a personal loan?
A personal loan is a lump sum of money that you receive from a lender with an agreed-upon payback plan typically that can be anywhere from a few months up to 5 years. They are also unsecured loans. This means there are no assets tied to the loan as collateral.
Since there is typically no collateral associated to back the loan, personal loans typically come with higher interest rates.
Determining your eligibility for a personal loan
In order to be deemed eligible for a personal loan, lenders will look at your credit report and income in order to make a lending decision. Specifically, they will look at your debt-to-income ratio (DTI), which measures your monthly debt payments as it compares to your monthly gross income. Lenders will also look at the history of how you 've paid your debt in the past.
One thing to keep in mind is that gross income is your income before any taxes or other deductions are taken out.
Why does knowing this matter? Well, when it comes to paying back your loan, you'll be doing it with your income after taxes and other deductions have been taken out. This means, although you may qualify for a large loan, you'll want to ensure you can truly afford to pay back the loan with your post-tax earnings.
Many online lenders offer personal loans at competitive interest rates. You can also apply for a personal loan at a bank where you already have a relationship.
If you find yourself needing to leverage a personal loan, it's a smart idea to determine how much you really need beforehand. This way you don't take on more debt than you have to. It's also smart to create a debt repayment plan as soon as possible. This will help you with a strategy to pay back the loan quickly.
What to know before you apply for a personal loan
Before you apply for a personal loan, there are a few key things you need to keep in mind.
Be aware of any associated fees
A personal loan typically comes with an origination fee which is separate from the interest charged on the loan. This is a payment associated with establishing the loan account and it is calculated as a percentage of the total loan. This percentage can range anywhere from 1% to 10%. As a result, origination fees can add considerable costs to a personal loan.
Other fees to consider include:
- Transaction fees
- Late payment fees
- Pre-payment fees (discussed below)
Make sure you can keep up with payments
If you are unable to make on-time payments or if you fall behind on your payments, your credit score will be impacted. So as mentioned before, you'll need to make sure you are not taking on more debt than you can afford to pay. On the flip side, if you are consistent with your on-time payments, it will have a positive impact on your credit score.
Understand the rules around paying off your loan early
Depending on your lender, making extra payments or paying off your loan early may not be allowed. If you are able to pay it off early, you could incur a pre-payment penalty for doing so. So before you sign anything, make sure you understand the pre-payment rules. Many lenders have no prepayment penalty so be sure to confirm this before you commit to a loan.
Be clear on your interest rate
When it comes to personal loans, your interest rate makes all the difference in what your monthly payments will be and also the total cost of the loan. As a result, it's really important you know what interest rate you are getting and whether it's a fixed or variable interest rate.
Variable interest rates can be attractive at first because they usually start off low. However, over time they can increase dramatically making your loan extremely expensive.
Make sure your lender is reputable
There are tons of online lenders offering all kinds of attractive personal loans. However, there are a lot of unsavory loans out there including payday loans which are a bad idea.
If you are concerned about the trustworthiness of a potential lender, visit the Consumer Financial Protection Bureau at consumerfinance.gov for more information on protecting yourself.
A personal loan can help you strategically pay off debt faster. For instance, consolidating debt into a personal loan may help to reduce your interest rate and lower your monthly payments. It can also help you cover major expenses like medical bills.
However, before applying for a personal loan, do your research, run your numbers and determine what will work best for you. Determine what you can truly afford and create a plan to pay back your loan as quickly as possible.