What Is a Personal Loan?

ByI. Mitic
July 29, 2021

When unexpected expenses arise, not everyone has the earnings or savings to cover them. In such situations, getting a loan is the only option. Seeing as borrowing money is a serious responsibility, we’ve decided to write a detailed guide in which we’ll cover the key points you should be aware of and give a few pieces of advice on how to go about acquiring the funds you need.

Personal vs. Other Types of Loans

So, what is a personal loan, and how does it differ from other loans?

There are many types of credit products, including credit cards, mortgages, lines of credit, and personal, pay-day, and education loans. Each one of them was designed to cater to a different goal or need you may have. Credit can often be a highly useful financial tool, but if not managed properly, it could cause you more harm than good, so the general advice is: Don’t bite off more than you can chew. (Not to mention that you should never settle for terms that seem unfavorable, but that’s a topic we’ll discuss more thoroughly later on.)

A personal loan is a form of credit you can use for a number of purposes. For example, you may use it for refinancing credit card debt, home improvements, buying a car, paying off medical bills, and so on.

Creditworthiness Assessment

Wondering whether you’re eligible for a loan? Lenders will usually look at the following items on your credit reports to determine your creditworthiness before offering you a loan:

Payment history: The main concern of any lender is whether or not you’ll be able to pay them back, which is why they closely examine your track record of timely payments. After all, if you haven’t been particularly committed to repaying your debts in the past, how can your creditor know that providing you with a personal loan isn’t a bad investment?

Outstanding debt: The logic behind your outstanding debt being a factor in the lender’s decision-making process is similar to that involving payment history. Borrowers who don’t seem very good at managing their financial obligations are considered poor credit applicants.

Length of credit history: It may be unfair to those just starting out in life or those who have spent most of their adult lives as stay-at-home parents, but a long record of responsible credit use goes a long way when applying for a loan.

New accounts: Stretching yourself too thin is not only an unhealthy approach to life but is an extremely dangerous tactic when it comes to owning large amounts of debt. If you open several credit cards in a short time span, your potential lenders will wonder why you suddenly decided to do that, and they’ll tend to question your capability to successfully manage all that credit.

Income: Your regular earnings have to exceed the overall amount of money you owe. While researching personal loans, you’ll see this criterion referred to as the DTI (debt-to-income) ratio.

Types of credit used: A diversified portfolio of credit products can improve your chances of obtaining a loan because it shows that you are experienced using multiple credit sources. It may sound a bit contradictory to what we’ve been saying up until now but note that what’s important here is variety, not quantity.

Assets: It’s expected of you to pay back your loan using your income, but some lenders may want the extra insurance of knowing that you possess assets that can be sold quickly, such as stocks or bonds.

Types of Personal Loans

As you shop around for the perfect offer, you’ll encounter terms such as fixed-rate, adjustable-rate, secured, and unsecured loans. We’ll explain them one by one.

Fixed-Rate Loan

When a loan has a fixed rate, it means that the interest rate doesn’t change throughout the life of the loan. The main benefit of these loans is that you won’t experience any surprises. You’ll know exactly the amounts of your monthly payments, and you’ll be able to calculate in advance the total cost of your loan.

Adjustable-Rate Loan

The interest rate of an adjustable-rate loan changes over time. If you choose to take out a loan such as this one, know that it comes with substantial risk. Although the initial interest rate of these loans is typically quite low, market conditions can make it increase significantly. That being said, most lenders will not raise the rate beyond a specific limit they’ve set in place.

Adjustable-rate loans aren’t as common as fixed-rate loans and are a good idea only if you believe you’ll be capable of repaying the debt quickly.

Secured Loan

Before you get a personal loan, you’ll also need to choose between a secured and unsecured one. A secured loan entails providing your lender with some sort of collateral. Collateral can be a great number of things, such as your house, car, investment account, and even items of fine art and jewelry. Whichever asset you decide to pledge as security for paying back your loan will be taken away by the lender if you fail to fulfill your financial obligation.

Due to this contingency system, secured loans are usually easier to obtain, which is why people looking for loans that don’t require a high credit score tend to prefer them.

Unsecured Loan

An unsecured loan, by definition, doesn’t require any kind of collateral. Consequently, personal loan lenders are likely to demand high credit scores from their applicants. However, there’s a way for you to acquire this type of loan even if your credit reports aren’t spotless – your friend or family member can become your co-signer. The catch is that if you default on a loan, they’ll be responsible for paying it off.

Despite that you’ll generally pay more interest with an unsecured loan, it’s still a solid option if you’re in the market for fast loan approval and flexible terms.

How To Get a Personal Loan

To those who have never done it before, getting a loan may seem like a daunting task, but actually, the process couldn’t be simpler. Here are the seven easy steps to follow:

Calculate how much you’ll need – in this particular case, more isn’t better because you have to be able to cope with the monthly payments. Don’t forget that some lenders charge an origination fee, which is deducted from your loan proceeds. Therefore, make sure that the sum you borrow is sufficiently large so that you get enough money even after the fee is subtracted.

Check your creditworthiness – as we’ve already mentioned in the Credit Assessment section of our “What is a Personal Loan?” article, lenders review plenty of factors to judge if you’re a viable investment. Know that even if your credit is below average and you don’t have the time to fix it, there are companies that specialize in assisting clients with poor credit scores.

Determine your loan type – only you can know for sure which loan type would suit you best.

Do your research – look at offers by banks, credit unions, and online lenders. Analyze their annual percentage rate and the terms and amounts they provide. Also, dig deep to figure out what additional fees they might charge.

Submit your personal loan application – nowadays, most lenders will let you apply online, and only some banks and credit unions ask that you complete a part of the process in person.

Provide the necessary documents – your chosen lender will let you know if they need you to upload or bring any specific documents. These can range from your driver’s license to your last pay stub.

Accept the loan – once you’ve been approved, you’ll be asked to accept the loan terms officially. The speed at which the funds will be credited to your account varies from lender to lender, but, in general, expect them in under a week.

Pros and Cons of Personal Loans

We’ll conclude our guide by quickly summing up the main pros and cons of this loan product, so let’s jump right in.

The primary reason why these loans are so popular is that they are flexible and easy to manage. In addition to that, consumers with solid credit scores can qualify for substantial amounts and low interest rates.

On the other hand, the fees that cover loan processing can accumulate to a hefty sum, and those with too many negative marks on their credit reports will have a hard time finding satisfactory terms.

Frequently Asked Questions
What is a personal loan, and how does it work? +

You can read our guide for more details on this subject, but the gist is that these loans are installment loans, meaning that you borrow a certain sum from a lender and are expected to pay it back with interest within a predetermined period.

What are the disadvantages of personal loans? +

This type of loan can be quite expensive for those with a less-than-perfect credit history since lenders consider these clients high-risk. By making borrowers with low credit scores pay higher interest rates, the lenders are protecting themselves from situations in which the people they lend to can’t continue making their monthly payments.

What is a good personal loan rate? +

Any interest rate below 10% is considered good for this type of loan. However, the lower your credit score, the higher the interest rate will be. If you’d like to learn more about the various factors that lenders look at when assessing your application, we suggest you read the Creditworthiness Assessment section of our “What is a Personal Loan?” article.

About author

For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.

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