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Credit cards aren’t the only option when it comes to financing purchases or consolidating debt. Personal loans are a popular choice thanks to digital offerings that make it easier to apply and get approved.
But before you sign on the dotted line, you need to make sure a personal loan is right for you. To do this, you need to understand the inner workings of this borrowing tool. You don’t want to end up with an expensive loan that you haven’t figured out or aren’t able to repay.
Rewind ten years when consumers had fewer options when it came to borrowing money. They could use a credit card, which usually meant paying high interest rates, or apply for a bank loan, which was hard to get without prime credit. The 2008 recession changed that.
With few consumer loans from banks, a slew of financial technology startups (or FinTechs) have emerged to offer personal loans to consumers. By using different underwriting data and algorithms to predict risk, they created a booming market.
According to TransUnion, the credit reporting company, unsecured personal loans reached $138 billion in 2018, an all-time high, with much of the growth coming from loans issued by FinTech companies. Average loan size in the fourth quarter of 2018: $8,402. Fintech loans account for 38% of overall activity in 2018; five years ago it was only 5%.
Related: Compare personal loan rates
How Personal Loans Work
Personal loans come in many forms and can be secured or unsecured. With a secured personal loan, you have to offer collateral or an asset that is worth something in case you cannot repay the money you owe. If you default, the lender gets that asset. Mortgages and auto loans are examples of secured debt.
With an unsecured loan, the most common type of personal loan, you are not required to post collateral. If you don’t repay the money, the lender can’t seize any of your assets. This does not mean that there are no repercussions. If you default on an unsecured personal loan, it will hurt your credit score, which will increase the cost of borrowing, in some cases dramatically. And the lender can take legal action against you to collect the unpaid debt, interest and fees.
Unsecured personal loans are typically used to finance a large purchase (like a wedding or vacation), to pay off high-interest credit card debt, or to consolidate student loans.
Personal loans are issued in the form of a lump sum which is deposited in your bank account. In most cases, you are required to repay the loan over a fixed period at a fixed interest rate. The payback period can be as short as one year to ten years and will vary from lender to lender. For example, SoFi, an online lender, offers personal loans with terms between three and seven years. Goldman Sachs’ Rival Marcus offers loans with terms of three to six years.
Borrowers who don’t know how much money they need can also take out a personal line of credit. It is an unsecured revolving line of credit with a predetermined credit limit. (In that respect, it’s a lot like a credit card.) The interest rate on a revolving line of credit is usually variable, meaning it changes with the prevailing market interest rate. You only repay what you take out of the loan plus interest. Lines are commonly used for home renovations, overdraft protection, or emergency situations.
Your credit score dictates the cost of borrowing
When assessing whether a personal loan makes sense, you need to consider your credit score. It’s a number ranging from 300 to 850 that rates the likelihood of you repaying your debt based on your financial history and other factors. Most lenders require a credit score of 660 for a personal loan. With credit scores below that, the interest rate tends to be too high to make a personal loan a viable borrowing option. A credit score of 800 and above will get you the lowest interest rate available for your loan.
To determine your credit score, many factors are taken into account. Some factors carry more weight than others. For example, 35% of a FICO score (the type used by 90% of lenders nationwide) is based on your payment history. (More FICO facts are here.) Lenders want to be sure you can handle loans responsibly and will look at your past behavior to get an idea of how responsible you will be in the future. Many late or missed payments are a big red flag. In order to maintain this part of your high score, make all your payments on time.
Second is the amount of unpaid credit card debt, relative to your credit limits. This represents 30% of your credit score and is known in the industry as the credit utilization ratio. It looks at how much credit you have and how much is available. The lower this ratio, the better. (For more, see The 60 Second Guide To Credit Utilization.) The length of your credit history, the type of credit you have, and the number of new credit applications you’ve recently completed are other factors that determine your credit score.
Apart from your credit score, lenders look at your income, work history, cash flow, and total amount of debt. They want to know that you can afford to repay the loan. The higher your income and assets and the lower your other debts, the better you look in their eyes.
Having a good credit rating when applying for a personal loan is important. This not only determines whether you will be approved, but also the amount of interest you will pay over the life of the loan. According to ValuePenguin, a borrower with a credit score between 720 and 850 can expect to pay 10.3% to 12.5% on a personal loan. This rises to between 13.5% and 15.5% for borrowers with credit scores between 680 and 719 and between 17.8% and 19.9% for those between 640 and 679. Less than 640 and it will be too cost prohibitive even if you can be approved. Interest rates at this level range from 28.5% to 32%.
There is a compromise
Personal loans can be an attractive way to finance a big purchase or get rid of credit card or other high-interest debt. The terms are flexible, allowing you to create a monthly payment that fits your budget. The longer the term, the lower the monthly payment.
But there is a compromise. You pay interest for a longer period. In addition, the personal loan interest rate increases with the term of your loan.
Take the example of a personal loan from SoFi. On a loan of $30,000, a borrower with the best credit will pay 5.99% for a three-year loan. who jumps to 9.97% for a seven-year loan. At Citizens Financial Group the interest rate is 6.79% for a three-year loan and 9.06% for a seven-year loan. At LightStream, a unit of SunTrust Bank, the interest rate on a three-year loan starts at 4.44%. For seven years, expect to pay 5.19% interest.
In addition to the interest rate, some lenders charge a loan origination fee, which is the cost of processing your application. This can make the cost of borrowing higher. The good news: origination fees are starting to disappear, especially on digital platforms. Some of the online lenders that do not charge borrowers origination fees include SoFi, LightStream, Marcus By Goldman Sachs and Serious. All require at least a 660 credit score. When shopping for a personal loan, compare the annual percentage rate or APR. It includes the interest rate and fees to give you a complete idea of how much you will pay.
If you have a good credit rating, a personal loan is a reasonable option for financing a large purchase or consolidating debt. If your credit score is less than excellent, paying a higher interest rate may be worth it if it means getting yourself out of even higher rate debt. Before you jump in, do the math. Consider the interest rate, fees and terms. If you end up paying thousands of dollars to consolidate your debt, this isn’t the best option for you.