Every year, millions of Americans use personal loans to consolidate debt, pay for unexpected expenses, make home improvements and more.
The number of people with personal loans has increased in recent years from 23 million to more than 27 million, according to TransUnion. In fact, personal loans were the fastest growing loan product in 2016.
So, why are personal loans appealing to so many? Personal loans offer low interest rates for consumers with good credit, and they are generally smaller loan amounts than other types of loans. But they aren’t necessarily the best solution for everyone.
If you’re thinking about getting a personal loan, here are a few things to consider before you make your decision.
6 things you should know about personal loans
- How personal loans work
- Types of personal loans
- Where you can get a personal loan
- Personal loans vs. other lending options
- Impact on your credit scores
- Interest rates and other fees
Personal loans are a type of installment loan. That means you borrow a fixed amount of money and pay it back with interest in monthly installments over the life of the loan — which typically ranges from 12 to 84 months. Once you’ve paid your loan in full, your account is closed. If you need more money, you have to apply for a new loan.
According to David Reiling, CEO of Sunrise Banks, it’s important to think about why you need the money and then choose the type of loan that’s most appropriate based on your current financial situation.
There are two types of personal loans — secured and unsecured.
- Unsecured loans aren’t backed by collateral. The lender decides whether you qualify based on your financial history. If you don’t qualify for an unsecured loan or want a lower interest rate, some lenders also offer secured options.
- Secured loans are backed by collateral, such as a savings account or CD. If you’re unable to make your payments, your lender typically has the right to claim your asset as payment for the loan.
Banks are probably one of the first places that come to mind when you think of where to acquire a loan. But they’re not the only type of lender that offers personal loans.
Credit unions, consumer finance companies, online lenders and peer-to-peer lenders also offer loans to qualified applicants.
Quick tip: Many internet lenders have emerged in recent years. If you’re not sure whether a lender is legitimate, consider checking with the Consumer Financial Protection Bureau or Better Business Bureau.
While personal loans can provide the cash you need for a variety of situations, they may not be your best choice. If you have good credit, you may qualify for a balance transfer credit card with a 0% introductory APR. If you can pay off the balance before the interest rate goes up, a credit card may be a better option.
How a balance transfer can help you pay down debt
Be aware: If you get a balance transfer card and can’t pay off your balance or make a late payment before the introductory rate expires, you may rack up hundreds or thousands of dollars in interest charges.
If you’re a homeowner, you might consider a home equity loan or line of credit, sometimes called HELs or HELOCs, respectively. These type of loans could provide the financing you need for larger loan amounts at low rates. While HELs are generally installment loans, HELOCs are a type of revolving credit. But, beware, your house becomes the collateral for these types of accounts. If you default, your lender usually has the right to foreclose on your home as payment for the loan.
When you apply for a loan, the lender will pull your credit as part of the application process. This is known as a hard inquiry and will usually lower your credit scores by a few points.
Interest rates and fees can make a big difference in how much you pay over the life of a loan, and they vary widely from lender to lender. Here are some things to consider.
- Interest rates: Rates typically range from around 5% to 36%, depending on the lender and your credit. In general, the better your credit, the lower your interest rate will be. And the longer your loan term, the more interest you’re likely to pay.
- Origination fees: Some lenders charge a fee to cover the cost of processing the loan. Origination fees typically range from 1 to 6% of the loan amount.
- Prepayment penalties: Some lenders charge a fee if you pay off your loan early because early repayment means that the lenders are missing out on some of the interest that they would have otherwise earned.
Before signing on the dotted line, consider adding up all the costs associated with the loan, not just the interest rate, to determine the total amount of money you’ll be responsible for repaying.
While a personal loan may be a good option if you’re in need of extra cash for a specific purpose, there are many factors to consider before deciding what type of credit is best for your situation.
“I think the most important thing … is the amount of debt you put yourself in, making sure you feel comfortable that those are payments you can afford and making sure [the loan is] structured in a way that you don’t feel trapped,” Reiling says.