Considering a personal loan? Learn the basics first
Personal loans are a great way to pay for unplanned expenses like car repairs, to consolidate high-interest credit card debt or just get cash at a low rate for any old reason.
But before you borrow, know the basics of personal loans.
Unlike a car loan or a home mortgage, personal loans are not secured by collateral. Lenders offering personal loans may want to know why you are borrowing funds; however, in most cases you can do what you wish with the money.
Personal loans require you to make set payments on a regular schedule (usually monthly), over a specific period of time. This is different from revolving loans like credit cards, which only require you to make minimum payments and have open-ended terms.
Consolidate and refinance debt
The interest rates on credit cards often are much higher than rates on personal loans. Consolidating debt and getting a lower interest rate could help you pay off debt sooner.
If your student loan rate is high, you may be able to refinance the loan to a lower rate, saving you money.
To be sure, do your research before moving forward. Student loans are often tax-deductible. If you refinance your student loan through a personal loan, you won’t be able to deduct the personal loan payments from your taxes.
Pay for a major purchase
It’s smart to avoid making purposes with unsecured personal loans unless you’re buying or replacing something you need, and you don’t have the cash to pay for it.
Even so, if you’re going to finance something that you’re buying from a retailer, such as furniture, a personal loan may come with a better interest rate than the store’s financing offer.
Sometimes, retailers offer zero percent financing for a set time period, such as the first 12 months of the loan. If you can pay the loan off within 12 months, this is a good deal. If not, check and see what the rate will be after the introductory period.
Sometimes, retailers offer the choice between zero-percent financing for a fixed period or a cash discount. Getting a low-interest loan from a bank or credit union and taking the cash rebate may save you money.
Improve your credit
In certain situations, obtaining a personal loan might improve your credit score.
One of the factors that determines your credit score is your credit utilization ratio. This is the difference between the amount of credit you have available to you and your actual debt. The ratio is calculated by dividing your debt by the credit you have available.
For example, if you have $10,000 in credit available but only have $2,500 in debt, your credit optimization ratio is 25 percent. A credit utilization ratio of 35 percent or less is considered best.
Having a low credit utilization ratio can improve your credit score.
Shop around for the best rate
The interest rate on a personal loan is set by the lender based your credit score and your total debt compared to your income.
Shopping for the best rate could save you hundreds of dollars. Before you apply for a loan, ask about credit qualifications. You want to make sure you’re likely to be approved before applying.
Remember, each loan application triggers an inquiry into your credit and lowers your score slightly. Applying for several loans can negatively impact your credit score.
You can minimize how many points you lose when lenders perform hard inquiries into your credit. Fair Isaac Corp. (FICO), the credit scoring company, considers all inquiries for loans within a 45-day period as a single inquiry. So, if you are shopping for a loan, apply for several within a 45-day window.
Check out secured loan options
While many personal loans do not require collateral, you might ask about a secured personal loan options. Securing your loan with money in savings, certificates of deposit or stocks can lower your interest rate.
This reduces the cost of your loan and allows you to pay it off quicker. However, if you default on the loan, the lender can take the asset you used as collateral to cover its losses.
A personal loan might be your best option when you’re buying a big ticket item that your family needs. But keep these facts in mind when you consider your options. And remember to make those payments on time!