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A personal loan is usually unsecured, meaning that the lender doesn’t require collateral, such as a home, car, or boat, to loan you money. The lender takes a greater risk, but in return for this benefit, you’ll be charged a higher interest rate than with a secured loan.
The interest rate on your loan will be influenced by several factors, including your credit score, debt-to-income ratio, and the size of your requested loan, among others. Most lenders cap loans at anywhere from $20,000 to $50,000, but some will go as high as $100,000 for well-qualified borrowers.
Minimums can range down to as little as $500 in some instances.
While it can be easier to put a lump sum in your pocket with a personal loan, it comes with the same downside that can be harmful to your credit score and ability to borrow at other times if you fall behind on your payments.
Common Reasons People Take Out Personal Loans
Personal loans are not the cheapest form of access to larger sums of money, but they’re not the most expensive either. Before taking out a personal loan, you must do some due diligence to see if there are less expensive options you can tap into.
Those people who do take out personal loans do so for a variety of reasons.
Consolidating Higher Interest Debt
Credit card interest rates are the most onerous of all personal debt, with interest rates that can hover near 30 percent. Personal interest loans are about half that cost and possibly cheaper, making them a smart move if you’ve got other higher interest rate debt.
Consolidating debt lets you pay down the balance faster, and it is psychologically less stressful to pay off a single debt than several over the course of a month.
To counter this, many credit cards offer a free balance transfer or low-rate introductory period, which may be a better choice if you can retire the debt quickly. If not, you may be shuffling from card to card often.
Before you use a personal loan this way, check to see if your old debt has prepayment penalties and what your new loan application and origination fees are to give you an accurate picture of what your savings are.
Financing a Major Purchase
If you can’t qualify for a low-interest credit card and you have a major expenditure in the near future, such as home improvements or other similar outlays, a personal loan may be a decent option for you.
You may be able to take out a secured loan at a cheaper rate but doing so means you’re putting that asset at risk, such as taking out a home equity loan or a HELOC.
Paying for a Major Life Event
People often consider a personal loan to pay for a wedding, milestone anniversary or a bar or bat mitzvah, which are usually cheaper than the other preferred way of financing these events through a credit card.
Lack of Collateral
People may turn to personal loans because they are unsecured debt, meaning you don’t have to put up your house or your car to lessen the risk to the lender.
A Short Lending Window
You might also consider a personal loan if you want to borrow money for a fairly and well-defined period. Personal loans typically run from 12 to 60 months and can provide a perfect financial bridge if you have short-term cash flow problems.
Factors That Impact Personal Loans
Borrowers with a high credit score and pristine payment history will get better interest rates for a personal loan because there is less perceived risk to the lender. Lenders will also look at a borrower’s income and employment status, which will have a material effect on how likely a loan will be repaid.
Lenders make more money on longer-term loans because the debt has more time to accrue interest. To protect their profits, some lenders may charge a prepayment penalty when a borrower pays off their loan too quickly. This is an important question to ask as you go through the lender vetting process.
Banks’ Cost to Borrow
Banks borrow from each other and from customer deposits. Rates are based on current federal funds rates. When their cost to borrow is more expensive, so is yours as it is passed on to the consumer.
Secured vs. Unsecured Loans
When a borrower secures a loan with collateral assets, they can borrow money at a cheaper rate due to less risk for the lender.
Personal Loan Benefits and Risks
Here are some pros and cons to think about if you’re considering a personal loan.
- No risk of foreclosure or losing your asset if you don’t repay the unsecured loan
- Quick loan decisions in as little as 3-5 days
- A simple application process
- Rates are usually lower than on credit cards
- Can be used for any purpose in most cases
- A shorter repayment period than other forms of credit
- Can be costly if you don’t have great credit
- Borrowing limits may be lower than on a home equity loan or HELOC
- Interest is usually not tax-deductible, unlike a home equity loan
- Some lenders may require you to specify how you’ll use loan proceeds
Personal Loan FAQs
Where can I apply for a personal loan?
You can submit an application to any bank, credit union, or online lender. Some lenders only approve loans for existing customers, so you may be restricted to some degree. In all cases, it pays to shop at various lenders to find the best terms and loan amount for your particular needs.
What credit score do I need?
Experts state that you’ll need a FICO score of 700 or above for an unsecured personal loan most of the time. However, some lenders may be more lenient and approve borrowers with scores in the 600-640 range. You will undoubtedly pay more for the privilege of a loan if your score is lower.
What are typical loan origination fees on a personal loan?
Most lenders charge an upfront origination fee of 1-5%. Again, this varies widely and is one of the points to consider as you shop for a lender.
What are the tax consequences of personal loans?
Personal loans are not considered income or subject to federal income tax. Interest on personal loans is not tax-deductible, but if personal loans are partially or completely discharged or forgiven as part of a personal bankruptcy or a debt restructuring, the amount not paid will be considered income and will be subject to federal income tax.
Are credit cards considered personal loans?
They are similar because both are forms of unsecured credit. However, personal loans are lump sum loans made by lenders to consumers with a specific repayment term and fixed interest rate. Credit cards are revolving lines of credit with balances that can be paid back over time or paid in full each month.
What about using a co-signer to help get loan approval?
A co-signer is agrees to repay a loan if the primary borrower cannot. They are often used when someone has a limited or blemished credit history. However, co-signors are also liable for the loan, and any missed payments could impact their credit history and score.
What if I am denied a personal loan?
When your application is denied, federal law gives you the right to know why. Based on this input, you can chart another strategy to secure funds, whether improving your DTI, credit score, and bill payment history or working with a co-signor.
What happens if I can’t make loan payments after approval?
If you run into financial problems through a job loss or illness and start to run into trouble making personal loan payments, contact your lender ASAP. They can help you explore possibilities to minimize your current situation.
Where can I get my credit score?
- Check your credit card or loan statements, which often provide you with the means to access your current score.
- Talk to a nonprofit credit counselor at the Department of Housing and Urban Development (HUD).
- Use a credit score service
- Buy your score through a credit reporting company or through myFICO.com.