- A personal loan is money that you receive from a bank, credit union, or online lender and pay back with interest over time.
- Personal loans are installment loans that are typically unsecured and can come with fixed or variable interest rates.
- Unlike other forms of financing, personal loans can typically be used for just about anything.
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Credit cards, mortgages, car loans, and student loans are all common forms of financing that you've probably heard of or may even have experience with. But you may be less familiar with personal loans.
What sets personal loans apart from other lending products? And when should you consider taking out a personal loan? Here's what you need to know about personal loans and when they could be a smart financing choice.
What is a personal loan?
A personal loan is money you borrow from a bank, credit union, or an online lender that you repay with interest over a set period of time. Many lenders offer personal loans that are either fixed-rate (the interest rate remains the same over the loan's term) or variable-rate (the interest rate is subject to change over the loan's term). The interest rates on personal loans vary by applicant, depending on your credit.
Unlike credit cards, which use revolving credit, personal loans are installment loans, like mortgages and car loans. In other words, all the money is issued up front and you repay the loan with fixed payments over a predetermined loan period.
Another feature that sets personal loans apart is that most of them are unsecured (like credit cards), meaning that you don't need to provide any collateral against the loan. The average interest rates on personal loans tend to be higher than secured loans like mortgages and auto loans, but lower than credit card interest rates.
How can a personal loan be used?
Flexibility in the use of funds is an area where personal loans really shine. Most installment-style loans are very specific about how funds must be spent. Mortgage loans must be spent on home purchases, student loans on education expenses, and auto loans for the purchase of the car.
But personal loans don't come typically with such restrictions. Borrowers can generally use the funds for just about anything they'd like. To offer up a few examples, you could use a personal loan to:
- Consolidate debt
- Renovate your home
- Start a business
- Pay for funeral expenses
- Cover moving costs
- Finance your wedding expenses
- Pay for an emergency expense (like an unexpected medical bill)
Any time you're thinking about taking out debt, you need to weigh the pros and cons. By taking out a loan instead of saving up to pay with cash, you'll end up paying more overall due to interest charges. But if you absolutely need the money now, a personal loan can help you cover a wide range of expenses.
Who is eligible for a personal loan?
Your eligibility for a personal loan and the interest rate you're quoted will depend on two primary factors: your credit score and your debt-to-income ratio.
Credit score requirements
Each personal loan lender is free to set its own credit score requirements. But according to FICO®, a score over 670 is considered "Good," a score over 740 is "Very Good," and a score over 800 is considered "Excellent." If your credit score is below 670, you may still qualify for a personal loan.
But it's unlikely that you'll qualify for the best rates. If your personal loan application is rejected because of your credit score, you may be able to find approval by adding a credit-worthy co-signer to your application. Or if you have assets that could be used for collateral, you could try to apply for a secured version of a personal loan. (And while you're applying for loans, you may want to work on improving your credit score for the future.)
Personal loans have wide interest rate ranges. Depending on the lender you choose, a great credit score could qualify for a rate under 5%, while less-qualified borrowers could receive an APR over 30%.
Debt-to-income ratio
Your debt-to-income (DTI) ratio is found by dividing your total monthly debt payments by your monthly income. If you spend $500 towards debt repayment each month and you have a monthly income of $2,500, your DTI is 20% ($500/$2,500 = .20).
According to Wells Fargo, you're "looking good" if your DTI is below 35%. The bank says that borrowers with a DIT of 36% to 39% are in the "Opportunity to Improve" category, while borrowers with a DTI over 50% need to "Take Action" because they'll likely have limited lending options.
When is a personal loan a smart choice?
First, if you need multiple years to repay the money you borrow, a personal loan could be a strong option. Even if you could qualify for a 0% Intro APR credit card (which gives you an introductory period in which you won't owe interest on your balance, providing a good opportunity to pay down debt), the promotional periods on these cards don't typically last longer than 18 months. If you need longer than that to repay your money, a personal loan could be a better fit.
Second, a personal loan could be a good choice if you don't have any equity in your home and would like to fund a major renovation. Paying for home improvements can be a smart use of personal loan funds because the renovations could increase the value of your home. But if you have equity to tap, a home equity loan or home equity line of credit (HELOC) could offer lower rates.
Finally, the fact that a personal loan can be spent on just about anything could make it the right choice for anyone who needs to cover an expense that's not related to their home, car, or education.
Think a personal loan is right for you? See our step-by-step guide to getting a personal loan.
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