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A Guide to Personal Loans

Do you need or want to make a large payment for something but you don’t have the cash for it? This is a common situation for people to find themselves in.

Fortunately, you may be able to take out a personal loan. Personal loans can be incredibly helpful, but there are a number of factors that you should know about personal loans before you decide to apply for one.

The following is a basic overview of what you can use personal loans for and how personal loans work:

Using Personal Loans

Personal loans can be used in many different ways, from relieving a financial burden to helping you pay for something you want that isn’t a necessity.

The following are some of the common reasons borrowers take out a personal loan:

  • Consolidating your credit card debt
  • Starting a business
  • Paying for medical bills
  • Paying for renovations or repairs to your home
  • Covering your moving expenses
  • Paying for a vacation
  • Paying for a personal item
  • Paying for a large wedding

How Personal Loans Work

When you take out a personal loan, you’re given a lump-sum of money. The amount you are given depends on various factors, including the amount you requested, your income and your credit history, to briefly name a few.

There are two types of personal loans – secured loans and unsecured loans. Both will be required to be paid off monthly over the course of an agreed upon loan term.

Secured Personal Loans

A secured loan requires you to put up collateral for your loan. This is often done for larger loans and helps to limit the risk that the lender is taking on the borrower. If you default on your secured personal loan, the lender will take your collateral.

Secured loans differ from other types of loans that require collateral. While home mortgage loans or car loans use the item you’re purchasing – the home or the car – as collateral, secured loans do not.

Instead, the collateral you’ll need to put up for a secured loan may include your savings account, your car equity or your home equity. The more money you have in your account or the more equity you have in your home or car, the easier it will be to obtain a secured personal loan.

Unsecured Personal Loans

As you might be able to guess, an unsecured personal loan does not require any collateral on the part of the borrower. Most people prefer to take out unsecured personal loans for this very reason.

However, there is much more risk involved for the lender, which is why it’s more difficult to qualify for an unsecured personal loan than it is to qualify for a secured personal loan.

Generally speaking, you will need to have a high credit score, steady employment, and little debt in order to qualify.

Personal Loan Interest Rates

When you take out a personal loan, the lender will charge you monthly interest. There are many different factors that go into determining what your interest rate will be.

Some of these factors include the amount you’re borrowing, how much you’re paying every month and how long the term of the loan is.

The perceived risk of the borrower has a big impact on the interest rate as well. This means that things like your credit score, your payment history and your debt-to-income ratio all matter. The less of a risk you are perceived to be as a borrower, the lower the interest rate will typically be.

Last but not least, your interest rate will be affected by whether you take out a secured or unsecured loan. Because you have to put up collateral for a secured personal loan, there’s less of a risk for lenders. Secured personal loans therefore tend to have lower interest rates than unsecured personal loans.

Keeping all of these factors in mind, you can expect the interest rate on a secured loan to be anywhere from 5 to 10 percent, whereas the interest rate on an unsecured loan is more likely to be up to 18 percent.

Defaulting on Your Personal Loan

If you don’t make the monthly payments that were agreed upon as part of your personal loan, then you will end up defaulting. If you have a secured loan, this means that the lender may seize the collateral that you put up and then sell it to get some of their money back. This means that if you put up your home equity, they can actually seize your home and sell it.

Seizure of your collateral won’t usually occur until after you’ve missed several payments. Even after missing several payments, the lender will get into contact with you in an attempt to figure out a solution.

If you have an unsecured loan, then you won’t have to worry about repossession. If you’ve missed several payments in a row, then the lender will send your account to their collections department. They will attempt to contact you to settle the balance due. If they are unable to reach you or you cannot make any of the payments you owe, they will sell your account to a collection agency.

This generally happens after a couple of months. Once a collection agency takes over, they are likely to sue you if you continue to miss payments, which means that they can come after whatever money or assets that you might have – even though your loan was unsecured.

Fees and Penalties

There are a few fees and penalties that you should be aware of when taking out a personal loan. First of all, many personal loans have origination fees.

The origination fee is the fee used to pay the costs of the paperwork, research, and calculations that the lender had to do in order to determine your interest rate and approve your personal loan application. Some lenders may waive the origination fee to make their loans more appealing.

Personal loans also have late payment fees. If you don’t make your monthly payment on time, you’ll be charged a late fee. This fee differs from lender to lender. While most late fees are flat fees, some lenders charge a percentage of your payment.

Last but not least is the prepayment fee. Some lenders will charge a flat rate, a percentage of your remaining interest balance or a fee based on how much time is left on your term if you attempt to pay your loan off early.

These are some of the basic factors that you should know about personal loans. Understanding how personal loans work will give you a better idea as to whether a personal loan is right for you.

Applying for a Personal Loan

If you decide you want to apply for a personal loan, you’ll need to provide certain information to your lender in order to qualify.

The following is a breakdown of what you need to provide, as well as what your lender will look at to determine whether they approve your loan.

Lenders are going to be very thorough when it comes to approving a personal loan request. Depending on the lender, you may be required to provide the following information and supporting documents:

  • Your name, social security number, date of birth and mother’s maiden name along with proof of identification, such as your driver’s license, social security card, state ID or passport.
  • Your address, email and phone number as well as proof of your address, such as a copy of your lease or any recent utility bills.
  • Proof of your past income, such as your bank statements, tax returns, W-2 forms or your pay stubs.
  • The name of your employer, the address where you work and the employer’s phone number.
  • Your gross income and monthly debt obligations, which include everything from your rent and utilities to your student loans or credit card debts.

You may also be asked for other personal information, such as your previous address. Additionally, you’ll need to communicate the amount you want to borrow and possibly even factors like target loan term (the duration of the loan).

Remember: monthly payments will be smaller if your term is longer, but you’ll end up paying more in interest the longer your term is.

How to Qualify for a Personal Loan

There are a number of factors that your lender will look at to determine how big of a financial risk they are taking by approving your personal loan. Borrowers who are deemed too big of a risk will have their loan application rejected or may not qualify for the full amount requested.

In some cases, the lender will simply charge a higher interest rate as a way to mitigate the risk they are taking.

The following are some of the main factors that not only determine whether you qualify, but how much your interest will be:

Your credit score

Your credit score is an indicator of how healthy your finances currently are (and have been in the past). It gives lenders a good idea of whether you are financially capable or responsible.

Generally speaking, most lenders won’t approve your loan application if your score is below 580. However, a good score is considered to be anything above 680.

Fortunately, there are ways to improve your credit score to increase your chances of having your loan approved. The following are a few ways to boost your credit score:

Check your credit report for errors – You can request a free credit report from one of the three main credit bureaus. Go through your report to make sure that there aren’t any errors. Errors do happen and they can hurt your score, so you want to clear them up if they are present.

Pay down your debts – Paying down some of your debts (or paying them off if possible) can have a big impact on your credit score. Most people should work to pay down credit card debt first if possible, and focus on the credit lines that have the highest interest rates.

Make all your payments on time – Making payments on time will help your credit score while paying late or missing payments will hurt it, so make sure that you pay your credit card bills, utility bills and more on time and in full.

Even if your credit score is fair or somewhat good, you may want to boost it a bit more to help secure a lower interest rate on your personal loan if you have the time to do so.

Establishing your credit history

Your credit history helps lenders see how financially stable and responsible you’ve been over the years. Unfortunately, this can be an issue if you don’t have much of a credit history.

Having some credit, even if it’s just fair, is better than having no credit. You can begin building your credit by applying for a secured credit card.

Just be wary about applying to a bunch of credit cards at once. Having too many new lines of credit on your credit history is considered a red flag to most lenders.

Maintaining a positive payment history

Late payments and missed payments not only hurt your credit score, they look really bad on your credit history. Lenders are going to think twice about approving a personal loan if you have a history of not paying on time or not paying at all.

If you have a few blemishes on your history, then just make sure you don’t make any late payments or that you miss any payments from here on out. If you have a habit of accidentally forgetting to pay on time, consider setting up automatic payments.

This ensures that whenever you owe money on a bill, the money will automatically be withdrawn from the account that you set it up for. This way, you’ll never be late again.

Your debt-to-income ratio

There are two parts to the debt-to-income ratio that the lender will look at – your income and your debt. You will have to provide proof of income to your lender. There’s no way you’ll get approved without proof of steady income or a co-signer.

Lenders prefer that you have at least two years of work at your current place of employment as well. This shows them that your job is secure and that the income you are currently receiving is something that can be counted on.

Lenders will also look at how much debt you have. While your total amount of debt owed is certainly a factor, it’s the debt-to-income ratio that’s really important. You may have a million dollars in debt, but if you make ten million a year, then you’ll appear capable of handling it.

Basically, it’s ideal if your income is big enough to cover whatever debt you have in addition to the personal loan payments that you will need to make every month. Most lenders will prefer if you have a debt-to-income ratio of 36% or lower and will rarely approve anyone whose debt-to-income ratio is above 43 percent.

These are the basics to remember when applying for a personal loan. Keep these in mind as you consider your options.

Can You Afford a Personal Loan?

If qualifying for a personal loan isn’t going to be an issue for you due to a good credit history, then you may be more tempted to take out a large personal loan.

However, you should sit down and crunch the numbers to determine if you can actually afford to take out a personal loan.

In some cases, you may have no choice, but you should figure out what your ideal budget is so you know what to look for in terms of secured or unsecured loans and loan terms.

Identify the exact amount you need

It’s not a good idea to borrow more than you need. Don’t take out extra just to have a little extra spending money or because you’re unsure of what you actually need yet.

Doing so will only put you in more debt because your monthly payments will go up and cost you more money in interest. For example, if you’re borrowing money to remodel your kitchen, speak with your contractors beforehand to determine an accurate estimate before applying for a loan.

Understand the total costs of the loan

When you figure out your budget and what you can afford, you have to compare it to all of the costs of the loan, not just the amount you want to borrow.

If you need $12,000 to remodel your home, you won’t just be paying $3,000 a year over a four-year period; if your interest rate is 10% on this loan, you’ll end up paying $14,608.85 over the course of those four years.

This could put you over your budget, which would obviously be a problem – although you could extend the loan term to make your monthly payments more affordable.

Additionally, you need to consider the other costs involved with taking out a personal loan, such as the loan origination fee. The best way to judge how much a loan will actually cost you is by looking at the APR (annual percentage rate) of the loan and not just the interest rate.

The interest rate is helpful when comparing the terms of different loans, but the APR shows you the interest you’ll pay for the year and includes all of the costs of the loan.

Decide between a secured or unsecured loan

Once you know how much you need, what you can afford and what the cost of the loan for what you need will be, you’ll have an easier time looking for a personal loan that works for you.

It will also help you decide whether to get a secured or unsecured loan. While secured loans are riskier on the borrower’s behalf due to the fact that you must put up collateral, the interest rate is often drastically lower.

If you can afford to pay the loan with a higher interest rate, an unsecured loan might be the better option since it puts you in a position of less risk.

But if you decide you really need to take the loan out and you’re going to be stretching yourself financially to do so, a secured loan may be the way to go.

Using a Personal Loan to Pay Off Your Debts

If you’re thinking about taking out a personal loan because you want to consolidate your debts, then you should be very careful about crunching the numbers.

While consolidating your debts can be a very good idea that could potentially save you money, there are a number of things to consider, including:

Will you save money?

Will consolidating your debts actually save you money? Don’t just consider the fact that you will save money on your monthly payments – keep in mind the interest rates being charged on your other debts, such as your credit card debts.

Also, factor in how long it would take to pay off your other debts versus how long it will take to pay off your loan to determine if you’ll save money long-term as well as short-term.

Will you just accumulate more debt?

If you’re just trying to get temporary relief from your debt by reducing your monthly payments, you could find yourself in even more debt over the long term.

Make sure that you’ll be able to pay down your personal loan without incurring more credit card debt or else consolidation may just end up being a step backward.

What to Look for in a Personal Loan

Besides just looking for a loan that offers low-interest rates, you should keep your eye out for the following as well:

  • Low penalties – Find out how much the lender will charge if you’re late on a payment or want to pay your loan off early. Some lenders charge a percentage, some a flat fee.
  • Low or no origination fee – Compare origination fees. Some lenders will waive their origination fee, but they may charge you more in interest as a result.
  • No pre-computed interest – In a typical loan, interest is accrued every day. If you decide to pay off your whole loan, you’ll just pay your balance and the interest that has accrued since you took the loan out. With pre-computed interest, the interest of the entire loan is calculated and added to your balance up front. This means that you could lose a lot of money towards interest even if you pay your loan off early.

For information about our personal loans or to apply for one of our personal loans, be sure to contact us at Al-Gar Federal Credit Union today.