Personal Loans Buying Guide

If you need to cover an unexpected expense or consolidate your debt, a personal loan may be right for you. Personal loans often get deposited directly into your bank account and can be used pretty much however you see fit. In many cases, personal loans have lower interest rates than credit cards, which makes them an attractive option for financing purchases that you can’t afford with your on-hand cash alone. 

If you’ve never applied for a personal loan before, the process can be a little confusing and intimidating. But this guide is here teach you everything you need to know about personal loans so that you can sail through the application process with confidence.

1. Understand how personal loans work 

Personal loans typically offer lower interest rates than credit cards and can be used to finance almost anything, which is what makes them so appealing. You can use the money from a personal loan to pay for home repairs, fund a wedding, cover an unexpected medical expense or buy a used car, among other things.

Personal loans are repaid in fixed monthly installments over a period of about three to seven years. If you have good credit, you can usually get a personal loan at an interest rate between 6% and 20%. 

Personal loans can be secured or unsecured. Secured loans are backed by collateral like a car that the lender can collect if you default. Unsecured loans, on the other hand, aren’t backed by anything, so you don’t risk losing one of your assets if you can’t repay what you owe. Your credit score will suffer if you default, though, so only take out loans you can afford to pay back. 

Unsecured loans are much more common than secured loans. However, because they’re risky for lenders, they have higher interest rates and require better credit scores of at least 660, on average. If you don’t meet the eligibility requirements for an unsecured loan or you want a lower interest rate, you may choose to take out a secured personal loan instead. 

2. Make sure a personal loan is your best option

Just because you can use a personal loan for anything, doesn’t mean you should. Taking out a personal loan to fund a vacation or buy an expensive handbag is tempting, but isn’t wise. If you save up for those purchases instead, you will avoid paying interest on them and spare yourself a lot of money in the long run. 

Personal loans are a great option, however, if you’re in a pinch and need to pay for necessary expenses that are big or unexpected. Moving costs, funeral costs and home repairs are all hard to cover if you don’t have a sizable emergency fund. They are also a good idea when you are investing in something that will help you earn back more money in the future, like a website for your business or career training. Personal loans can help fill that gap in your savings at a lower interest rate than credit cards. 

You can also use a personal loan to consolidate old debts and save money. This works particularly well with credit card debts, which often have higher interest rates than personal loans. 

3. Determine your credit score 

Before you apply for a personal loan, it’s important to check your credit score for errors. Having a good, accurate credit score qualifies you for better interest rates and unsecured loans. If there are errors that reduce your score, you may end up missing out on better loans and interest rates. 

You can check your credit score by requesting a free credit report online from the three major credit reporting agencies — Equifax, Experian and TransUnion. It’s important to request a report from all three agencies because there are often minor inconsistencies between the reports. Making sure all three reports are accurate and updated will improve your chances of securing a loan. 

4. Find the best lenders and rates

After you’ve checked your credit score, you should start researching lenders that you might want to borrow from. Here are the Best Personal Loans of 2020 according to our evidence-based research. To further expand your list, check out online reviews of lenders from trusted sources. By the end of all that research, you should have a pretty sizable list of potential lenders that you can whittle down. 

There are a few factors you should consider when narrowing down your options. One is the maximum loan amount for each lender. Some lenders cap personal loan sizes at $25,000, while others allow qualified borrowers to take out larger loans of up to $100,000. Certain lenders may also have minimum amounts that you have to borrow in order to get a loan. For some lenders, that’s $1,000, and for others, it’s $10,000. Check each lender’s website to make sure that you’re able to borrow the amount of money that you need. 

Another thing you should consider is your eligibility for each loan, which is primarily based on your credit score, income, debt, employment history and repayment history. If your credit score is high, you probably won’t have an issue getting a loan from any lender. However, if your credit score is on the low side, you’ll have to find companies that accept subprime borrowers and don’t require strong credit histories. 

Other things to consider include the average annual percentage rate (APR) that the company offers and the average term, which is the period of time you’ll have to pay off the loan. If the bank typically offers short terms, you’ll have to make higher monthly payments, which may not fit with your budget. 

5. Calculate your repayment plan

Repayment plans are based on the size of your loan, the term you choose and the APR. Loans with shorter repayment terms generally have lower interest rates as a reward for paying them off quickly. But the trade-off is that your monthly payment will be higher. Here’s how to calculate interest on a personal loan.

Most personal loans have a fixed rate, which means your monthly repayment won’t change over the course of the term. The interest on most personal loans is usually calculated using simple daily interest, which saves you money over the life of the loan — compared to compound interest. Simple interest is determined by multiplying the number of days between payments by the daily interest rate by the principal. Unlike compound interest, it doesn’t factor in the interest the principal accumulates over the term, so it doesn’t cost you as much to pay down. 

If you’re curious about how much interest you’ll pay over the life of your loan, you can calculate simple daily interest by dividing your annual interest rate by 365 and multiplying it by your principal. So on a $5,000 loan with a 4% interest rate, you’d be paying about $0.54 a day. 

To get a better picture of what your entire monthly repayment on a loan will be, you can use a personal loan calculator. 

6. Pre-apply for your best options

Applying for multiple personal loans within a short span of time can negatively impact your credit score. But luckily, most lenders will pre-qualify you and allow you to see your personalized loan offers without hurting your credit score. 

To pre-qualify, lenders perform something called a soft inquiry on your credit score. Soft inquiries enable lenders to check your credit without hurting it as regular credit applications do. A soft inquiry is similar to when you check your own credit and it doesn’t change your score at all, so you should get pre-qualified by every lender you’re interested in to find the best interest rates.

7. Compare offers

The most important factors to consider when comparing personal loan offers are the rates and fees. These factors determine how much interest you’ll pay over the life of the loan, so you want to choose an offer with the lowest interest rates and fewest fees possible. 

One particular fee you should watch out for is the origination fee. Many lenders charge you for the cost of processing the loan and disbursing the money into your bank account. These fees can equal up to 8% (although they often range from 1% to 6%) of the total loan amount and are often rolled into the principal, raising the amount of interest you pay. To see how much fees will affect the interest rate of the loan, check out the APR. The APR is calculated using both fees and interest rates, so it better represents the total cost of the loan. 

Another factor to consider is loan size. How much money did each lender offer you, and does it meet your needs? Even if a lender is offering zero fees and competitive interest rates, it may not matter if the loan size isn’t big enough. 

You should also consider the size of the monthly payments. If you go with a loan that has a short term, you’ll pay less interest, but you’ll also end up with larger monthly payments. You’ll need to figure out how much you can comfortably afford to pay each month and go with a loan that fits your budget, while also offering a competitive cost overall. 

8. Understand the loan’s terms 

Before you commit to a loan, you should dig into the terms and conditions and make sure you really understand them. You should be clear on things like the payment terms, arbitration rules that dictate how conflicts are handled and any penalties and fees that are associated with the loan. Also, look for information about automatic withdrawals. If you choose to use automatic payments, you need to know when payments are going to come out of your account and how many times your lender can try to withdraw the payment when funds are insufficient. 

When you sign a contract, you really need to be aware of what you’re agreeing to. So if there’s lots of jargon in the terms and conditions of your loan that you don’t understand, it might be a good idea to run it by a trusted friend or family member to get a little advice, or ideally a financial consultant. After all, two heads are better than one. 

9. Apply for the loan 

To complete the application process, you’ll need to fill out more in-depth forms that fully document your financial situation. This process can include uploading documents like your pay stubs, tax returns and W-2’s as proof of income, so it helps to get those in order before you start the application process. You’ll also need to have your driver’s license or state-issued ID handy, as well as your Social Security card. 

Unfortunately, even if you have all of your ducks in a row when you apply for a loan, you may still be denied. Lenders have to give you a reason for rejecting you, though, because of the Equal Credit Opportunity Act. So within a few weeks of being rejected, you’ll know exactly why it happened and what you need to change to improve your chances next time. Possible reasons why your application may be denied include insufficient income, low credit score, derogatory marks on your credit report and a high debt-to-income ratio. 

Every lender has different requirements, and some are more stringent than others. So if you get rejected, don’t get discouraged. Figure out ways that you can clean up your credit report or increase your income and apply again. Ultimately, lenders are using data to gauge your likelihood of repaying the loan. Ashley Boucher, corporate communications director at Sallie Mae, explains this. 

“We assess a customer’s ability, stability and willingness to repay before making a loan. The result: 98% of our customers are successfully managing payments and fewer than 2% default,” she says.

10. Start paying it back as soon as possible 

The total amount of debt you have is a big factor in determining your credit score. Your outstanding debt accounts for 30% of your score, so owing a lot of money can really hamper your ability to get approved for new loans, credit cards and apartments. That’s why it’s important to start paying your loan back as soon as you can. 

If you can manage it, consider making extra payments on your loan. Tossing extra money at your loan every month will help you save on interest and free up more of your paychecks for savings. Before you start aggressively paying down your loan, though, you should take a close look at the terms and make sure that there aren’t any prepayment penalties. 

Prepayment penalties are a charge you get hit with if you pay off your loan early. Lenders collect prepayment penalties to make up for the interest they lose out on. Sometimes these fees can be prohibitively expensive, so you should do your best to find a loan without them. 

Closing thoughts

Personal loans shouldn’t be used for unnecessary expenses like costly vacations or cosmetic home upgrades. However, if you’re hit with an unexpected hospital bill that you don’t have the savings to cover, a personal loan can give you the money you need at an affordable interest rate. If you do your due diligence to review your credit reports, research lenders, compare offers and go over the terms of your contract carefully, you will likely be able to find the best personal loan available for your situation. So make sure you do your homework before you sign on the dotted line. 

Jessica Walrack

Contributing Writer

Jessica Walrack is a personal finance writer at SuperMoney, Interest.com, The Simple Dollar, and PersonalLoans.org. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.