Personal Loans 101 [Guide]
A personal loan is a convenient and predictable way to borrow money for a major purchase or unexpected expense. It is quite easy to obtain, and the interest rates are usually lower than those for credit cards and other short-term financing options.
Our personal loans guide uncovers two related but very different types of credit: personal loans and personal lines of credit. Keep reading as we explore these loan types, how they work, their rates and terms, and which option might suit you better depending on your financial situation.
Personal Loans
Personal loans are sometimes called signature loans when no collateral is required. While some lenders may offer lower rates if you secure your loan against your car or other major asset, most personal loans simply require your signature on a loan agreement.
You can use money from personal loans for a variety of things. There are generally few restrictions on what you put your money towards. Popular uses include:
- New furniture
- A wedding
- A vacation
- New appliances
- Home improvements
- Vehicle repair
- Medical expenses
- Debt consolidation
Applying for a personal loan is also generally quick and easy. Many lenders allow you to apply online, by phone, or in person.
How Do Personal Loans Work?
Personal loans are offered by credit unions, banks, and online lenders and have fixed interest rates and repayment terms for the life of the loan. If you are approved for a personal loan, you will receive a lump sum for the full amount upfront. You will then make equal monthly payments until the loan is repaid.
The payback period generally varies depending on the loan amount and may be as short as a year or as long as 10 years.
Some of the advantages of personal loans include:
- Fixed rates: Unlike credit cards your personal loan rate remains fixed for the loan term
- Predictable payments: With a fixed rate and loan term, you’ll know exactly what you owe every month and when you will be done making repayments
- Improved credit score: Regular, on-time payments on your personal loan will improve your credit score over time
One of the best things about personal loans is that you don’t necessarily need an excellent credit score to qualify. Most lenders will require a score of at least 580, which is considered fair. Applicants with higher scores can obtain the best rates and loan terms.
And, while your credit score determines a big part of your eligibility for a loan, lenders do look at other factors, including:
- Your income
- Your work history
- Your overall credit report
- Your debt-to-income ratio
Personal Lines of Credit
The other major type of personal lending is known as a line of credit. The primary difference between a line of credit and a traditional personal loan is that you do not receive a lump-sum payment upfront and there is no set monthly payment.
Instead, you have extended borrowing privileges that you can use when you are ready, and your payment is determined by how much of the line of credit you choose to use.
Rather like a credit card, with a line of credit, you receive a credit limit you can draw from as needed. You can borrow money up to your credit limit and repay only a monthly minimum.
The flexibility of lines of credit makes them great for projects where you need to periodically borrow money, like a home remodeling project, restoration project, or unexpected personal expenses.
How Do Lines of Credit Work?
Like personal loans, personal lines of credit are offered without collateral by many credit unions, banks, and other lenders. However, unlike loans, lines of credit let you prepare for future expenses by allowing you to borrow the money you need when you need it.
As with personal loans, there are few restrictions on how you use the funds from a line of credit and collateral is usually not required.
One popular feature of a line of credit is that many lenders only require interest-only payments on the money you borrow. This can come in handy during times when money is tight.
However, an important thing to remember about lines of credit is that they have variable interest rates, and the rate could vary greatly depending on different factors.
Also, a line of credit is active for only a specific period, known as the draw period. Draw periods vary depending on the lender, but up to 10 years is common. If you have not repaid all of the money you borrowed when the draw period ends, your rate will reset to a much higher (and still flexible) rate.
Many lenders also charge a balloon payment to catch up on payments or prepayment penalties so it’s harder to pay off your loan early.
How to Apply
The application process for personal loans and lines of credit is similar. You will need to complete an application and provide a range of required documents. These typically include:
- W2 or 1099 forms
- Pay stubs
- Bank statements
- Proof of address
- Income tax returns
- Your Social Security number
- A state-issued driver’s license, ID, or passport
How to Get the Best Rate
Be sure to shop around before you apply to get the best rate possible. It is also worth asking to pre-qualify with more than one lender. This will allow you to compare actual loan offers and see what different lenders offer.
When evaluating loan offers, it’s important to understand the difference between interest and the annual percentage rate (APR). Lenders charge interest as a fee for borrowing money. The APR includes the interest rate and provides a clearer view of the total loan cost by factoring in lender fees, such as origination charges, that are added to the loan amount.
When shopping for a lender, check out deals local credit unions offer. Freedom Credit Union operates as a non-profit co-operative run on behalf of its members. Because we’re not focused primarily on turning a profit, you may find our credit interest rates are lower than banks and come with fewer fees.
After you have selected a lender, you can then submit a formal application. A hard credit check will be done, and you should know whether you are approved within 1-7 days. Some lenders may even be able to approve your application the same day you apply.
Personal Loan or Line of Credit?
Personal loans and personal lines of credit are both readily available sources of funding and typically do not require you to provide any collateral. However, they are also very distinct types of borrowing designed to suit borrowers with different needs.
Personal Loans
Personal loans give you a single lump sum of money that you pay off in full over a set period. This is a better choice if you are looking to make a single major purchase, or want to consolidate and eliminate outstanding credit card debt or other forms of higher-interest borrowing.
Personal loans are generally a safer bet because you can match your repayment rates to your current income and budget predictable payments to pay off everything you owe over time. You’ll know up-front exactly how much you are borrowing and when you will have your loan paid off.
Personal Lines of Credit
Personal lines of credit allow you to borrow up to a set limit and repay flexibly, making them ideal for managing cash flow or planning for future expenses.
They’re often used for short-term needs, such as covering ongoing expenses. Similar to credit cards but with lower interest rates and potentially higher limits, they’re a good option for those with irregular income or anyone seeking an affordable way to fund small business costs or major home renovations.
Is Collateral Better?
If you do have a major asset like a car, boat, or even a home that you are willing to put up for collateral, you might be able to obtain a better APR or terms on your personal loan or line of credit. It’s a big step to put your home or another asset on the line to access more cash, but depending on the amount you borrow and the term, the savings could be significant.
If you’re exploring financing options, it’s also helpful to understand the difference between secured and unsecured personal loans, as these loan types can impact your borrowing decisions and terms.
Get Started on a Personal Loan Application
At Freedom Credit Union, we provide personal loans designed to help our members finance major purchases or consolidate debt into a manageable solution. With affordable payments and clear terms, our loans make it easier to include significant expenses in your long-term financial plan.
Contact us today to learn more about what a Freedom CU personal loan can do for you, or click below to get started on an application.
