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Credit cards are not the only option when it comes to financing purchases or debt consolidation. Personal loans are a popular option thanks to digital offerings that make it easy to apply and get approved.
But before you sign on the dotted line, you need to make sure that a personal loan is right for you. To do this, you have to understand the inner workings of this borrowing tool. You don’t want to end up with an expensive loan you didn’t understand or one you’re not ready to pay back.
Go back ten years when consumers had fewer options when it came to borrowing money. They can use a credit card, which usually means paying high interest rates, or apply for a bank loan, which would have been difficult to get without first-class credit. But the 2008 recession changed that.
With so little consumer lending done by banks, a handful of fintech startups (or FinTechs) have sprung up to offer personal loans to consumers. Using underwriting data and various algorithms to predict risks, they have created a market that is now thriving.
According to TransUnion, the credit registry, unsecured personal loans totaled $138 billion in 2018, an all-time high, with much of the growth coming from loans created by FinTech companies. Average loan size in Q4 2018: $8,402. Fintech loans accounted for 38% of all activity in 2018; Five years ago, it was only 5%.
Related: Compare personal loan rates
How do personal loans work?
Personal loans come in many flavors and can be secured or unsecured. With a secured personal loan, you have to provide a guarantee or an asset that is worth something in case you are unable to repay the money you owe. If you default, the lender gets those assets. Mortgages and auto loans are examples of secured debt.
With an unsecured loan, which is the most common type of personal loan, you don’t have to provide collateral. If you don’t pay the money back, the lender won’t be able to decorate 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, raising the cost of borrowing, in some cases significantly. The lender can sue you to collect the debts, interest, and fees owed.
Unsecured personal loans are typically used to finance a large purchase (such as a wedding or vacation), to pay off high-interest credit card debt or to consolidate student loans.
Personal loans are issued as a lump sum deposited into your bank account. In most cases, you are required to repay the loan within a specified period of time at a fixed interest rate. The payback period can be as short as one to ten years and will vary from one lender to another. For example, SoFi, an online lender, offers personal loans with terms ranging from three to seven years. Rival Marcus by Goldman Sachs offers loans with terms ranging from three to six years.
Borrowers who are not sure how much money they need can also get a personal credit line. This is an unsecured revolving credit limit with a pre-determined credit limit. (In this respect, it’s a lot like a credit card.) Typically, the interest rate on a revolving credit line is variable, meaning that it changes with the prevailing market interest rate. You only pay back what you take out of the loan plus interest. Lines are commonly used for home improvement, 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 assesses your likelihood of paying your debts based on your financial history and other factors. Most lenders require a credit score of 660 for a personal loan. With credit scores lower than that, the interest rate tends to be too high to make a person lend a viable option to borrow. A credit score of 800 and above will get you the lowest interest rate available for your loan.
When determining your credit score, a lot of factors are taken into account. Some factors carry more weight than others. For example, 35% of your FICO score (the type used by 90% of state lenders) is based on your payment history. (More FICO facts here.) Lenders want to make sure you can handle loans responsibly and will look at your past behavior to get an idea of your liability in the future. Lots of late or missed payments is a big red flag. In order to keep this part of your score high, make all your payments on time.
Coming in second is the amount of credit card debt you owe, relative to your credit limits. This represents 30% of your credit score and is known in the industry as credit utilization ratio. It looks at the amount of credit you have and how much is available. The lower this percentage, the better. (For more information, see The Sixty-Second Guide to Using Credit.) The length of your credit history, the type of credit you have and the number of new credit applications you’ve filled out recently are other factors that determine your credit score.
Aside from your credit score, lenders look at your income, work history, liquid assets, and how much total debt you have. They want to know that you can pay off the loan. The higher your income and assets and the lower your other debts, the better you will look them in the eye.
It is important to have a good credit score when applying for a personal loan. It not only determines whether you will be approved but also how much interest you will pay for 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. That goes up to between 13.5% and 15.5% for borrowers with credit scores of 680 to 719 and 17.8% to 19.9% for those in the 640 to 679 range. Below 640 and that would be very expensive even if you could get approved. Interest rates at this level range from 28.5% to 32%.
There is a tradeoff
Personal loans can be an attractive way to finance a big purchase or get rid of credit card or other high-interest debt. Terms are flexible, allowing you to create a monthly payment that fits within your budget. The longer the term, the lower the monthly payment.
But there is a trade-off. You pay interest for a longer period. Moreover, the interest rate on a personal loan increases the longer the term of the loan.
Take a personal loan from SoFi as an example. On a $30,000 loan, the borrower with the best credit will pay 5.99% for the three-year loan. This 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 the 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. It can make the cost of borrowing more expensive. The good news: Creation fees are starting to disappear, especially on digital platforms. Some of the online lenders that do not charge borrowers an origination fee include SoFi, LightStream, Marcus By Goldman Sachs, and Earnest. All require a credit score of at least 660. When shopping for a personal loan, compare the APR or the APR. It includes the interest rate and fees to give you a complete picture of how much you will be paying.
If you have a good credit score, a personal loan is a reasonable option for financing a major purchase or debt consolidation. If your credit score is less than excellent, paying a higher interest rate may be worth it if it means getting you out of debt with higher interest rates. Before you make the jump, do the math. Keep in mind the interest rate, fees, and terms. If you end up paying thousands of dollars to consolidate your debt, this is not the best option for you.