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When you have an unforeseen expense or need to make a purchase that exceeds your savings, you may have to go into debt to get by. If you need flexibility, you can opt for a form of revolving credit, such as a credit card or line of credit.
But if you need a specific amount of money on a one-time basis, it may make more sense to take out a personal loan, an installment loan that is paid off over a fixed term. You repay monthly until the loan is fully repaid.
Some large banks don’t offer personal loans, and those that do tend to have strict credit score criteria and turn away customers without a credit score of at least 670. That doesn’t mean that personal loans are hard to find; many credit unions and a growing number of online-only lenders offer several types of personal loans.
Common uses of a personal loan
While it’s always better to use the savings for large purchases and avoid going into debt, sometimes that’s just not an option. Personal loans should not be used lightly, especially if you can afford the expense while waiting and saving. If financing is a must, however, personal loans are often an attractive option as they often come with lower interest rates and higher limits than credit cards.
Some credits must be used for specific purchases, such as a car loan to buy a car or a mortgage to buy a house. But personal loans can be used for various purposes, such as:
- Consolidating higher-interest debt, such as credit cards or student loans
- Medical procedures not covered by insurance, such as fertility treatments or cosmetic surgery
- Holidays or weddings you prefer not to wait to save
- Home improvements or repairs
- Big purchases like a household appliance
Types of personal loans
The most common type of personal loan is an unsecured fixed rate loan, but some lenders offer other options that you should be aware of when shopping.
Unsecured personal loans
Most personal loans are unsecured, which means that no collateral is required to secure a loan. An auto loan uses your car as collateral, so if you can’t make your payments, the lender can repossess your car.
On the other hand, an unsecured personal loan does not have any physical assets, so if you have a hard time making payments, there is no asset that the lender can take away from you. Your strong credit history, and possibly that of a co-signer, is what secures the loan. If you are looking for an unsecured personal loan, you will generally need a good credit score (670 to 739) or better, according to the Experian credit bureau.
However, there are always negative consequences if you cannot repay your unsecured personal loan. If you make late payments it can hurt your credit, and if you don’t make payments, your personal loan account could collect and ruin your credit score in the process.
Since unsecured loans do not require any collateral, they are inherently riskier for the lender. So you can usually only qualify for an unsecured personal loan if your credit is strong.
Related: Compare personal loan rates for 2020
Guaranteed personal loans
If your credit can be improved, you may still be eligible for a personal loan, but the lender may require it to be in the form of a secured loan. This means that you will need to provide an asset to secure the loan, such as a vehicle, savings account, or certificate of deposit.
The good news is that the interest rate on secured personal loans is generally lower than that on unsecured loans. This is because there is less risk for the lender since they can take your collateral if you cannot make your payments.
Fixed Rate Personal Loans
Personal loans are generally fixed rate, which means that the interest rate stays the same for the life of the loan, just like your monthly payment. The advantage is that you will know exactly how much your payment will be each month, which will allow you to better adapt to your budget. You will also be able to know in advance the amount of interest you will pay over the life of the loan. A personal loan calculator can help you estimate your monthly payments before you apply.
Adjustable Rate Personal Loans
Although less common than fixed rate personal loans, some lenders offer adjustable rate personal loans. Rather than having the same interest rate forever, your interest rate is subject to change over time.
The appeal of variable rate loans, also known as variable or floating rate loans, is that the interest rate is usually quite low to begin with. After a certain period of time, the interest rate may increase depending on market conditions, so the monthly payment may go up or down.
While there are usually limits to keep you from paying more than a certain amount of interest, you run the risk of ending up with a higher rate and unpredictable monthly payments. For this reason, taking out an adjustable rate personal loan is generally only recommended if you can repay the loan quickly.
Personal loan alternatives
Personal loans are ideal for certain expenses, but you may want to consider other options before deciding on the best type of financing for you:
- Savings. This is not always possible if you need a loan to pay for an urgent expense, such as an unscheduled home repair or emergency medical intervention. But if it’s something that can wait, it’s smarter to save and pay cash. This keeps you from paying interest and keeps you from going into debt, which can negatively affect your credit and overall finances.
- Credit card. While personal loans are ideal for large purchases, credit cards are often best for small purchases over time. Part of the reason is that their interest rates are usually higher than those on personal loans, and you usually can’t borrow that much with a credit card. This is a form of revolving credit, which means that you have a line of credit that you can use as needed. You only pay interest on what you use, and once you’ve paid off your debt, you can re-borrow up to the credit limit. Plus, rather than paying off in fixed monthly installments, credit cards only require a minimum monthly payment. This offers more flexibility than personal loans, but since there is no fixed repayment schedule or term, it is easier to get into debt.
- Lines of credit. A line of credit is another form of revolving credit, where you have a credit limit and only pay interest on what you borrow. You have to repay a monthly minimum based on the amount you borrow, such as a credit card, and you can borrow the funds. One option is a personal line of credit, which is similar to an unsecured loan. Another option is a home equity line of credit, which uses your home as collateral. However, lines of credit act more like loans in that you have a reserve of cash to draw from rather than having to put purchases on plastic. When you have a line of credit, you typically access the money by writing a check or having the lender transfer it to your bank account.
- Payday loans. Consumers with poor credit who find it difficult to qualify for personal loans may turn to payday loans as a form of quick cash, especially since lending standards are minimal and loan amounts are low. loans are low. But payday loans are considered a predatory form of lending because the fees are astronomical and add up quickly, according to the Bureau of Consumer Financial Protection, leaving many trapped in debt. Avoid them if possible.
If you have a large expense in your life, there are many types of personal loans and other financing options to choose from. Just be sure to do your research, compare quotes from multiple lenders, and be aware of the impact a loan can have on your credit, both positively and negatively.