Personal Loans 101 [Guide]
Personal loans are popular financing options that many turn to for different purposes. They are relatively easy to obtain, and the interest rates are usually lower than the rates for credit cards and other financing options.
If you are wondering how to get a personal loan, there are two types to consider—traditional personal loans and lines of credit. There are several distinct differences in how the two loans work. Depending on your needs, one may be a better choice than the other.
Personal Loans
Personal loans are also sometimes referred to as signature loans because no collateral is required. There are some lenders, however, that do require collateral, but most do not.
You can use personal loans for a variety of things because there are usually few or no restrictions. A few popular uses include:
- Furniture
- A wedding
- A vacation
- Appliances
- Vehicle repair
- Medical expenses
- Debt consolidation
Applying for a personal loan is usually quick and easy. Many lenders now give you the option of applying online, by phone, or in person.
How Do Personal Loans Work?
Personal loans are offered by both banks and credit unions and have fixed interest rates. 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 varies depending on the amount you borrow and may be as short as a year or as long as 10 years.
One of the great things about personal loans is that you don’t necessarily need an excellent credit score to qualify. Many lenders require a score of at least 580, which is considered fair. Applicants with higher scores, however, may be able to obtain lower interest rates.
Lenders don’t just consider applicants’ credit scores when evaluating them for personal loans. They look at other factors including:
- Income
- Work history
- Credit history
- Current debt level
Instead of focusing on a single metric, such as your credit score, lenders consider the big picture when making loan decisions.
Lines of Credit
The second type of personal loan 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. There is no set monthly payment. Your payment is determined by how much of the line of credit you use.
With a line of credit. you receive a credit limit that you can draw from as needed. In many ways, these loans operate similarly to credit cards. You can borrow money and then repay it to replenish your credit limit.
These highly flexible loans are great for projects where you need to periodically borrow money, like a home remodeling project, restoration project, or something else. Some people even take out lines of credit to use as emergency backups.
How Do Lines of Credit Work?
Offered by both banks and credit unions, lines of credit allow you to borrow only the money you need when you need it. Similar to traditional personal loans, there are few restrictions on how you use the funds. Collateral is usually not required.
A feature of lines of credit that many people like is that some lenders only require interest-only payments on the money you borrow. This can come in handy during times when money is tight.
A line of credit is active for a specific period, which is known as the draw period. Draw periods vary depending on the lender, but 10 years is common while some lenders do not have a draw period limit. If you have not repaid all of the money you borrowed when the draw period ends, a balloon payment may be required where the full amount will be due.
An important thing to consider with lines of credit is that they have variable interest rates, and the rate could vary a great deal depending on different factors.
How to Get a Good Rate and Apply
The application process for both personal loans and lines of credit is similar. Information you will need to complete a loan application may include:
- Pay stubs
- W2s and 1099s
- Bank statements
- Proof of address
- Income tax returns
- Social Security number
- State-issued ID or passport
To get the best rate possible, be sure to shop around before you apply. It may also be worth your time to pre-qualify with more than one lender. This will allow you to compare loan offers to see which one has the best terms. Soft credit checks are done when lenders pre-qualify so it won’t negatively affect your credit score.
When comparing offers, it’s important to understand the difference between interest and the annual percentage rate (APR). Interest is the fee that lenders charge for the use of the money you borrow, and it is usually expressed as a percentage. The APR includes the interest rate, but it gives borrowers a clearer picture of the total cost because it also includes the lender fees.
When shopping for a lender, be sure to check out the deals that your local credit unions offer. Credit unions operate as non-profit organizations and are primarily focused on serving the needs of their members. Because they are not focused on turning a profit, their interest rates are usually lower than banks and they have 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 to 7 days. Some lenders may approve your application the same day you apply.
How to Get a Personal Loan Right for You
Although most personal loans don’t require collateral, you may be able to obtain a better interest rate if you have collateral you can use. Depending on the amount you borrow and the term, the savings could be significant.
Be sure to check out the following article to learn more about the differences between secured and unsecured personal loans to help you determine which option is best for your needs.
