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Credit cards aren’t the only option when it comes to financing purchases or consolidating debt. Personal loans are a popular choice thanks to digital offers 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 need to understand the inner workings of this borrowing tool. You don’t want to end up with an expensive loan that you don’t understand or are ill-equipped to pay off.
Go back ten years when consumers had fewer options for borrowing money. They could use a credit card, which usually involved paying high interest rates, or apply for a bank loan, which was difficult to obtain without first-rate credit. The 2008 recession was a game changer.
With few consumer loans from banks, a host of FinTech startups (or FinTechs) have emerged to offer personal loans to consumers. By using different algorithms and underwriting data to predict risk, they created a booming market.
According to TransUnion, the credit rating company, unsecured personal loans reached $ 138 billion in 2018, a record high, with much of the growth coming from loans issued by FinTech companies. Average loan size in the fourth quarter of 2018: $ 8,402. Fintech loans represent 38% of overall activity in 2018; five years ago it was only 5%.
Related: Compare personal loan rates
How personal loans work
Personal loans come in many forms and may or may not be secured. With a secured personal loan, you have to offer collateral or an asset that is worth something in case you can’t pay back the money you owe. If you default, the lender gets that asset. Examples of secured debt are mortgages and auto loans.
With an unsecured loan, the most common type of personal loan, you don’t have to post collateral. If you don’t pay back the money, the lender can’t seize 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, which will dramatically increase the cost of borrowing in some cases. And the lender can take legal action against you to collect the unpaid debt, interest, and fees.
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 in the form of a lump sum which is deposited into your bank account. In most cases, you have to repay the loan over a specified period at a fixed interest rate. The repayment period can range from one year to ten years and will vary from lender to lender. For example, SoFi, an online lender, offers personal loans with terms of between three and seven years. Goldman Sachs rival Marcus offers loans with terms of three to six years.
Borrowers who don’t know how much money they need can also take out a personal line of credit. This is an unsecured revolving line of credit with a predetermined credit limit. (In this respect, it looks a lot like a credit card.) The interest rate on a revolving line of credit is usually variable, which means it changes with the prevailing market interest rate. You only pay back what you took out of the loan plus interest. The lines are commonly used for home renovations, overdraft protection or for emergency situations.
Your credit score dictates the cost of borrowing
When considering whether a personal loan makes sense, you need to consider your credit score. It’s a number ranging from 300 to 850 that rates the likelihood of you paying off your debt 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 this, the interest rate tends to be too high to make a personal loan a viable borrowing option. A credit score of 800 and above will get you the lowest interest rate available on your loan.
In determining your credit score, many factors are taken into account. Some factors carry more weight than others. For example, 35% of a FICO score (the type used by 90% of lenders nationwide) is based on your payment history. (More FICO facts can be found here.) Lenders want to make sure that you can handle loans responsibly and will look at your past behavior to get a feel for your level of responsibility in the future. Lots of late or missed payments are a big red flag. In order to keep this part of your score high, make all of your payments on time.
Next is the amount of current credit card debt, relative to your credit limits. This represents 30% of your credit score and is known in the industry as the credit utilization ratio. It looks at how much credit you have and how much is available. The lower this ratio, the better. (For more, see the Guide to Using Credit in 60 Seconds.) The length of your credit history, the type of credit you have, and the number of new credit applications you’ve recently completed are the most common. other factors that determine your credit score.
Apart from your credit score, lenders look at your income, employment history, cash flow, and total debt amount. They want to know that you can afford to pay off the loan. The higher your income and assets and the lower your other debts, the better you look in their eyes.
It is important to have a good credit rating when applying for a personal loan. It not only determines whether you will be approved, but also how much interest you will pay over 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. This increases between 13.5% and 15.5% for borrowers with credit scores of 680 to 719 and from 17.8% to 19.9% for those in the 640 to 679 range. Less than 640 and it will be. too expensive even though you can get approval. Interest rates at this level range from 28.5% to 32%.
There is a compromise
Personal loans can be an attractive way to finance a large purchase or to get rid of a credit card or other high interest debt. The terms are flexible, allowing you to create a monthly payment that fits your budget. The longer the term, the lower the monthly payment.
But there is a compromise. You pay interest for a longer period. In addition, the interest rate of the personal loan increases with the length of the term of your loan.
Take the example of a personal loan from SoFi. On a $ 30,000 loan, a borrower with the best credit will pay 5.99% for a three-year loan. This climbs 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 a 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. This can make the cost of borrowing higher. The good news: origination fees are starting to disappear, especially on digital platforms. Some of the online lenders that don’t charge borrowers setup fees include SoFi, LightStream, Marcus By Goldman Sachs, and Earnest. All of them require at least a credit score of 660. When shopping for a personal loan, compare the annual percentage rate or APR. It includes the interest rate and fees to give you a complete idea of how much you will be paying.
If you have a good credit rating, a personal loan is a reasonable option for financing a large purchase or consolidating debt. If your credit score is less than stellar, paying a higher interest rate may be worth it if it means getting yourself out of even higher rate debt. Before taking the plunge, do the math. Consider the interest rate, fees and conditions. If you end up paying thousands of dollars to consolidate your debt, this is not the best option for you.