How Do Personal Loans Functions | Things You Must Know

Credit cards are not the only option when it comes to financing or consolidating debt, you may be asking how personal loans function.

Personal loans are a popular choice thanks to digital offerings that usually make it easy to apply and get approved.

However, before you sign on the dotted line, you have to make sure a personal loan is good for you.

To achieve that, you have to understand the inner workings of this borrowing tool.

You wouldn’t want to end up with an expensive loan you don’t understand or one you are ill-equipped to service.

Rewind to 10 years when consumers had lower options when it came to issues borrowing money.

They could opt for a credit card, which is usually meant for paying high-interest rates and apply for a bank loan, which was hard to get without a good credit score.

However, the 2008 recession changed that and it was introduced to aid the system.

With the little barrier in the way of consumer lending being executed by banks, a section of financial technology startups emerged to offer consumers personal loans.

By using different data and algorithms to predict risk, they created a market that is now booming.

And according to TransUnion, unsecured personal loans peaked at $138 billion in 2018 alone, that’s an all-time high, with much of the revenue coming from loans originated by FinTech companies.

How Personal Loans Work

Personal loans come in different packages and can be secured or unsecured depending on what you are looking for.

With the secured personal loan, you have to present collateral or an asset that is worth something in case you cannot pay the money that you owe.

If you fail to meet up the quota, the lender gets that collateral. Mortgages and auto loans are also examples of secured debts.

Unsecured loans are the most common type of personal loan, you are not required to offer collateral.

If you cannot pay back the money borrowed, the lender can’t have any assets to seize. However, that does not mean that there aren’t repercussions to it.

Defaulting on an unsecured personal loan will hurt your credit score, which will raise the cost of borrowing, in the future.

And the lender can also file a lawsuit to collect the outstanding debt, interest, and fees from you.

Personal loans are issued as a given sum that is deposited into your bank account. In most cases, you are also required to pay the loan over a fixed period at a fixed interest rate.

Equally important, the payback period can be as short as 1 year and as long as 10 years and will also be different from one lender to another.

For Instance, SoFi is an online lender that offers personal loans with terms between 3 to 7 years. Rivals like Marcus by Goldman Sachs offer premium loans with terms ranging from 3 to 6 years.

Customers who are not sure about how much money they need can also acquire a personal loan. This is an unsecured revolving line of credit with a predetermined credit limit.

Your Credit Score Dictates the Cost Fee

Weighing a personal loan makes sense, you just have to consider your credit score. It is a number from 300 to 850 that rates the likelihood of you paying back your debt based on your financial history.

Most lenders ask for a credit score of 660 for a personal loan. With credit scores lower, the interest rate tends to be too high to make a personal loan viable.

A credit score of 800 and above will get you a low-interest rate that is available for your loan.

Coming in second is the amount of credit card debt outstanding. That accounts for 30% of your credit score this is also known as the credit utilization ratio. The lower that ratio the better.

Having a nice credit score when applying for a personal loan is very important. It not only determines if you will get approved but also how much interest you will have to pay throughout the loan.

Personal loans can be a very attractive way to fund a purchase or to get rid of another high-interest debt.

The terms are still flexible, allowing you to create a monthly payment that will fit into your budget. The longer the term period, the smaller the monthly payment.

But there is a trade-off, you have to pay interest for a longer period. What is more, the personal loan interest rate increases the longer the term period of your applicable loan.

Meanwhile, the interest rate on a revolving line of credit is typically different, meaning it can change with the prevailing interest rate in the market.

Summary

In addition to the interest rate, some lenders also charge a loan origination cost commission, which is the fee to process your application.

That will make the cost of borrowing expensive. The good news is that origination fees are starting to disappear, particularly on all digital platforms.

Some of the online lenders that don’t charge their customers the origination fee commission include SoFi, LightStream, and Marcus by Goldman Sachs.

All that is required is to have at least a 660 credit score. When shopping for a personal loan, make sure you compare the annual percentage rate (APR).

This includes the interest rate to give you the full picture of how much you are meant to pay.

If your credit score is less than required, paying for a higher interest rate may be worth it if it means getting yourself out of even higher-rate debt. But before you decide, you can do the math.

Make sure to consider the interest rate, terms, and fees too. If the cost ends us higher than expected please know that it is not the best option for you at the moment.