How Do Personal Loans Work?

Loans have become integral to many things, like buying a house, starting a business, and even servicing credit card debt. While there are different types, more and more people are applying for a personal loan thanks to certain advantages it has.

A personal loan refers to a specific amount of money obtained from a bank, an internet-based lender, or a credit union. Once procured, you can use it for anything, provided you pay it back according to the agreed schedule.

Usually, the lender asks for monthly installments, including the accrued interest. The best part about getting a personal loan is that you will enjoy a fixed interest rate over the repayment period. While basking in its benefits, it has something even better.

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You can choose to get an unsecured loan. Yes, that means no need for collateral to obtain it. Now that you know what it is, let’s answer the question, how does a personal loan work?

The initial step to getting a personal loan is to complete an application process, then wait for approval. Different lenders have unique procedures for giving out this advance, which may take a few hours to a few days. Once approved, the lender disburses the funds to your bank account.

One thing you should know is that lenders of most personal loans give credit reports to the credit bureaus. Hence, you have an opportunity to improve your credit score with it.

Types of Personal Loans

Personal loans are beneficial, helping you achieve your endeavors without the overbearing requirements of others. However, you might miss out if you don’t know the different types. You could get either a secured or an unsecured personal loan.

Both have their respective advantages, as we will see shortly, but the flexibility is undeniable. Personal loans remain one of the best ways to purchase cars and houses, fund an event, or start a business. Notwithstanding, you have the flexibility to put down collateral or skip it.

Let’s explain the different types you can get today without hassles.

Secured Personal Loan

In secured personal loans, the lender requires some form of security in the event of a default. You can pay a lump sum or use assets like a car, house, boat, farm, etc. The aim is for the lender to have something to fall back on if you fail to pay up the loan amount.

We can say that a secured personal loan is the amount of money you get after putting down collateral. In a way, this type protects you by offering a way out if you can’t pay up with cash. They are among the most common you will see.

So, what happens if the loan period elapses and you can’t pay it back? Based on your agreement, the lender has the right to seize the property you offered as collateral. Often, the lender will sell the collateral to get back the money.

While secured personal loans provide security for the lender, they are not common. Instead, unsecured personal loans are more easy-to-find if you need money to make a quick fix.

Let’s point out one last thing. Auto loans often do not require collateral because the online lender or bank already regards the car as collateral.

Unsecured Personal Loan

Despite being based solely on trust, unsecured personal loans are more common than secured ones. The lenders trust the borrower, hence the absence of collateral. How can someone trust another to repay a loan, you might wonder?

An unsecured loan may not require collateral, but they need something else. There must be some form of a previous record to establish the trust that you will pay back. Without it, procuring one can be daunting.

A high credit rating is essential to obtaining this type of advance. Your credit history must be above average, if not stellar, and missed payments should be absent or at the barest minimum.

An unsecured personal loan interest rate is usually high, considering the lack of collateral. Notwithstanding, you can always weigh multiple lenders to determine the best interest rates.

This advanced cash is your best bet to deal with unexpected expenses, medical bills, home renovations, etc. Remember that the digital lender is taking a higher risk by lending without collateral. As a result, you may have to deal with a higher annual percentage rate.

We have explained the two major types of personal loans, but there are, in fact, other types.

Other Types of Loans

The following are alternative installment loans if you don’t fancy the secure and unsecured options:

  • Fixed-rate Loans: Fixed-rate loans are the way to go if you want to make consistent monthly payments. The rates stay the same throughout the life of the loan. With fixed-rate loans, you can effortlessly plan your monthly budget without worrying about changing rates.
  • Variable-rate Loans: As the name implies, variable-rate loans are the opposite of fixed-rate loans. Bank benchmark rates control the interest rate, bringing fluctuation as the benchmark fluctuates.

One advantage this loan has is that the APRs are lower, and you might even end up with a more affordable monthly payment. Though the rates vary, they could also tilt in your favor.

  • Debt Consolidation Loans: You can shed the stress of repaying multiple lenders by consolidating monthly payments into one. That is the opportunity that debt consolidation loans offer, but they are better if they carry a lower APR. So, consolidate your debts into one and worry less.
  • Co-signed and Joint Loans: What happens if you don’t qualify for a personal loan. Well, there is a way out. Co-signed and joint loans allow a third party (co-signer) to join the contract.

While only you can access the funds, the co-signer offers to pay if you don’t. Joint loans, however, differ in the third-party structure. In this case, the co-borrower has access to the funds and is responsible for repaying the loan.

As for fielding a co-borrower, you will want to go with someone with a strong credit report.

How Do I Get a Personal Loan?

Before you get a personal loan, do these things first:

  • Increase your credit rating: Work on your credit reports and improve your credit score. You might get lower monthly payment rates and more favorable loan terms.
  • Clear your debt as much as possible: Clean up existing loans, especially credit card debt, and you might get good terms from digital lenders.
  • Weigh your options: Compare the amounts, loan terms, and total interest from other financial institutions or lenders before settling for one.

Once you decide on the interest rate and lender, the personal loan application process is as follows:

  • Submit required documents: The next step to borrow money is to make a formal application. Usually, this process involves submitting several details, including bank statements.
  • Obtain your loan: Once approved, the online lender or bank pays the money into your savings account or any other account you provide. Sometimes, you may have to pay origination fees, which the lenders charge.

How Does a Personal Loan Affect Your Credit Score?

A credit score applies to any debt you owe to a bank, digital lender, or credit union. The credit bureau receives reports from the financial institution or union and rates the borrower accordingly. You score higher if you have a solid commitment and payment history.

Keeping that in mind, personal loans work the same way. They can improve your credit score, especially if you consolidate other debts like credit card debts. Credit cards are revolving lines of credit, but loans are better.

Aside from consolidating a credit card debt, maintaining consistent payments also affects your credit score. Note that it goes both ways. If you default, your ratings plummet, but if you stay consistent, your scores rise.

Now you know that you can use your personal loan to improve your credit score. Enjoy the benefits of low rates and favorable loan terms while beating the credit report to a punch. The key is to repay it on time, even if it is a high-interest debt.

Alternatives to Personal Loans

The following alternatives will serve you in place of a personal loan:

  • Credit card: Credit card is a revolving line of credit that offers holders repeated access to borrowed funds. You can use them to pay for anything while deferring the repayment date. It is handy for making quick purchases but has variable rates.

Also, it is not the most suitable for higher expenses. If you can, use them sparingly and prepare the balance before the billing cycle ends. That way, you will maintain a good credit score if you want to apply for other loans.

  • Peer-to-peer loans: Peer-to-peer (P2P) loans remove the need for a financial institution or broker. They present a viable option for those seeking alternatives to banks. However, they carry higher default rates, so take note of that.

P2P lenders who want better returns on their cash get on these websites or platforms and give out their money. On the other hand, borrowers on P2P platforms often seek better rates.

  • Personal line of credit: You can obtain this line of credit from your bank. Unlike credit cards, this type of loan has lower risks. You can access the funds and pay them back within the approved period.
  • Home Equity Loan: Home equity loan offers a lump sum of money as a second mortgage. You can enjoy lower rates when you take this loan against the equity on your home.
  • 401(k) loan: A 401(K) loan comes from your retirement savings account, with employers being the primary providers.

How Personal Loans Can be Used?

Personal loans are at your disposal, and nobody will instruct you on how to use them. Whether you want to buy a car, a house, fund an event, or a business, the choice is yours. The opportunity to enjoy fixed interest rates makes them a perfect choice for many.

You can use your loans for anything, including:

  • Small Home Improvements: Finally, you can fix that crack on your wall even when there is little money in the wallet. Moreover, you will also enjoy affordable interest rates and favorable repayment periods.

Home improvement loans provide an even better opportunity to embark on a home project without using your house as collateral.

  • Expensive Events: Let’s say you want to host a fund-raiser but don’t have enough cash. Personal loans can fill the gaps in your budget, boosting your ability to deliver a quality event.
  • Emergencies: This advance can save you from medical emergencies, house damage, funerals, and other unanticipated events. We don’t always have enough cash to take care of these situations.
  • Debt Consolidation: As mentioned earlier, you can collapse your debts into one, meaning one monthly payment takes care of them. Personal loans help you achieve this with lower interest rates.
  • Investing in Yourself: You can spend the life of a loan pouring investments on yourself. It could be learning a craft, getting a professional certification, etc.
  • Repair your car: The same way you can use this loan to buy a car, you can also use it to run repairs and servicing on your vehicle.

How to Choose a Personal Loan?

  • Credit score requirement: Checking credit score requirements is crucial to know which loans you can obtain. Low credit scores hardly qualify, but you can still move forward.

Surmounting a poor credit history often involves dropping collateral. Your credit history shows how you managed past loans, and lenders are unlikely to offer you money if it is abysmal.

Always check the credit score requirement. Make the necessary preparations ahead of time, even if you don’t qualify immediately. Also, you can use Credit Karma to get free credit scores and credit reports.

  • Interest Rates: Interest rates top up the loan amount during repayment. Lenders want to make money from giving you money, and they do that through interest rates. This information is paramount to your entire experience.

Favorable rates will always favor prompt payments, leading to good credit history in the future. Most personal loans have low rates, but you might need to dig deeper to find them.

Interest rates do not only refer to the monthly installments but also cover annual percentage rates. You can also use a loan calculator to find the best one to avoid late or missed payments.

  • Origination fees: One final piece of information you need to look out for is the origination fees, which the lenders charge. You might be lucky enough to get a loan without one, but the probability is small.

The last thing you want is an initial price that will put a dent in your finances.

Conclusion

Now, you know how personal loans work. You can use them to buy a new car or house, fund an event, remodel your home, or do whatever comes to mind, without restrictions. Also, the process of obtaining a loan amount is relatively easy, provided you have a good credit rating.

Unsecured loans require no collateral but may offer higher APRs. You can try other alternatives, but avoid credit cards if you can. If necessary, you can use personal loans to improve your credit report.

Finally, take note of the credit score requirements, loan term, and lender reviews before procuring the money.

FAQ

  • What is a good interest rate on a personal loan?

Generally, a good interest rate is one you can pay comfortably without missing a monthly installment. The aim is to cut back on the interest as much as possible. Luckily, some lenders are willing to part with their money for an interest rate as low as 10.3%.

  • Is it hard to get a personal loan from a credit union?

Credit unions will happily give you a personal loan if you have a good credit score. They are even more friendly than banks and are ready to offer you affordable loan costs. However, depending on the union, you must be a member for a certain period of time.

  • What disqualifies you from getting a personal loan?

Low credit scores are the primary parameters that disqualify you from getting it. Lenders often review your credit history and performance to assess your readiness to repay the loan amount. Notwithstanding, things like monthly or annual income may also disqualify you.

  • What is a typical interest rate on a personal loan?

A typical personal interest rate is 15.5%, but you can get a lower rate if your credit score is high. Maintain a good rating, and you can get a rate of 10.3% with flexible terms. On the other hand, poor credit scores will typically place you at higher rates.

  • Do personal loans affect credit score?

Personal loans affect credit scores because online lenders, credit unions, and banks submit reports to the credit bureau. Maintain consistent payments, and you will have good ratings from the lenders. Also, high scores, in the long run, will qualify you for more favorable terms.

  • Do personal loans require down payments?

Some lenders may require down payments before issuing the loan. Unlike unsecured loans, secured loans require collateral (a down payment). However, the collateral can be a lump sum or an asset like a house.

Your ability to put down this downpayment qualifies you for such loans.

  • Do banks give personal loans?

Financial institutions like banks offer personal loans if you meet their minimum requirements, but they are seldom affordable. High rates and stiff repayment terms are the hallmarks of their loans. For this reason, many defer to credit unions and online lenders for better rates, fixed monthly payments, and flexible repayment periods.

  • Are Online Personal Loans Safe?

Online personal loans are safe, but ensure they are from a reputable lender. Monthly payments and annual percentage rates are the only things you will face. Aside from that, personal loans will not pose a problem. Moreover, you can use them for anything of your choosing without limitations.

  • How long does it take to get approved for personal loan?

Depending on the lender, it could take a few hours to a few days. Most online platforms will process your request within hours and disburse the funds to you. However, failure to submit all the required documents on time could delay you from obtaining the loan.