Personal Loans 101: Everything you need to know
What you need to know about personal loans
By Jean Chatzky
Personal loans may have been shunned in years past, but they are undergoing a resurgence as consumers realize they can get a better rate on a personal loan than on a credit card.
And it doesn't hurt that it may even help borrowers' credit score. That's because personal loans are treated as a fixed-term loan when calculating your credit score while a credit card is counted as a revolving line of credit. As a result, personal loans are treated more favorably from a credit score point of view.
But not all personal loan lenders are created equal. Nor are the terms, interest rate and fees they charge. That's why consumers have to understand the inner workings of a personal loan before shopping for one.
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Most personal loans are unsecured, which means you aren't putting up your house or car as collateral. But that lack of physical backing makes you more of a risk and, as a result, the interest rate you pay on a personal loan is often higher than on a secured one.
That doesn't mean borrowers automatically pay high rates. Rates can be as low as 6% for people with stellar credit.
Pay attention to the interest rate
Paying close attention to the interest rate a lender is charging is extremely important when shopping for a personal loan.
Your credit score will dictate what range you fall into, but the exact percentage you pay will vary from one lender to the next. That variation can be about 500 basis points, or 5 percentage points, says Sam Mischner, a senior vice president of an Internet lending marketplace operator.
That may not seem like a lot but it can add up quickly, and "dramatically change the affordability of the loan," he says. Because the interest rate can be different from one lender to the next, consumers have to make sure they are shopping around for the best rate.
Compare with other types of borrowing
But that's not the only thing borrowers have to consider when it comes to the interest rates. They have to look at it in comparison with other ways of borrowing. After all, using a credit card to make a purchase could be a better option if the interest rate is lower. It's not the case that often for borrowers with good credit.
Personal loan interest rates often are better than credit card rates, but you won't know until you research the interest rates on both products.
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Another thing personal loan borrowers have to know about the interest rate on the loan is whether it's fixed or variable. A fixed rate means the interest rate is locked in over the life of the loan. A variable interest rate changes when other interest rates do.
The good news is most personal loans have a fixed interest rate. "Personal loans tend to be a fixed interest rate, fixed term and fixed payment," says Carey Ransom, chief exploration officer at Payoff, the Costa Mesa, California-based financial services company.
"Predictability is a good thing, especially in the environment we now may be entering into where interest rates start to climb," he says.
In mid-December, the Federal Reserve raised rates by 0.25%, and many industry watchers expect the Fed to continue to increase rates in 2016.
Avoid hefty origination fees
A close 2nd to understanding the interest rate is any fee associated with borrowing money through a personal loan.
"With many companies, the interest rate is not the full story," says Daniel Macklin, co-founder of SoFi, the San Francisco lender.
Lenders are in the business to make money and they will make as much as possible off of you if you let them. That's why you have to get up to speed with the fees they attach to the loan.
"The loan will come with an origination fee and an application fee," says Mischner.
He says the origination fee is usually less than 2% of the loan. See an origination fee higher than that, and you should consider shopping elsewhere.
Some lenders even impose a prepayment penalty, if you pay off your loan before a certain date. Understanding all the fees associated with the loan will enable you to do an apples-to-apples comparison of lenders when shopping for a personal loan.
Using a loan for debt consolidation or vacation
As what people use personal loans for, the reasons vary as much as the rates that lenders charge. One of the most popular is debt consolidation.
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Macklin at Sofi says many customers are using personal loans to refinance and pay off expensive credit card debt while others take out personal loans to cover unexpected expenses or even to pay for vacations or weddings.
At the end of the day, cash is always king, but if you have to borrow money, a personal loan could be an option, granted you've done your homework.
The lending institution you belong to may offer you an attractive interest rate on a personal loan, but it might not be giving you the best offer available. The only way to know if you're getting the best deal is to compare several lenders.