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Personal loans are one of the fastest growing loan products on the market. Known for their versatility, they can be used to consolidate credit card debt, pay for a necessary home repair, or even fund a tropical vacation. But a personal loan doesn’t make sense for everyone.
If you’ve already determined that a personal loan is right for you, here’s how to navigate the personal loan marketplace and get the best deal.
The Process of Getting a Personal Loan
- Why Should You Get a Personal Loan?
- Run the Numbers
- Check Your Credit Score and Credit History
- Decide the Type of Loan You Need
- Shop Around and Pick a Lender
- Submit an Application
- Read the Contract
- Provide Documentation
1. Why Should You Get a Personal Loan?
People apply for personal loans for all kinds of reasons — but not all of those choices are financially sound or make sense for your situation. Some common reasons to get a personal loan include consolidating credit card debt, funding home repairs and renovations, and financing weddings and vacations.
In general, we recommend taking on debt only if it’s a necessary expense and if you can afford it. Consolidating credit card debt onto a low-rate personal loan, for example, can make monthly payments more manageable and save you money in the long term. However, taking out a $30,000 personal loan for a wedding can lead to financial strain and hurt your credit score. And a personal loan to help replace a damaged roof would be more responsible than using it to replace your kitchen countertops. Ultimately, it’s best to take on as little debt as possible — and if you do still need a personal loan, then take the time to get the lowest rate and most friendly loan terms possible.
2. Run the Numbers
Before applying for a loan, make sure you understand what you’re trying to accomplish. Are you trying to consolidate credit card debt? Are you covering funeral expenses you can’t pay fully out of pocket? Are you planning a vacation you can’t afford? Personal loans are not a free meal ticket. They will have to be paid back eventually, at greater cost, so determine if taking on debt is the best solution for your situation.
From there, you can figure out how much money you need to borrow, and crucially, how much you can afford to borrow. Say you want to borrow $10,000 to replace the HVAC system in your home. If you’re offered a three-year personal loan at a 4% interest rate, then your monthly payment would be about $295. If that exceeds what you are able to handle in your budget, then you’ll either need to take out a smaller loan or extend the life of your loan to, say, five years. Farnoosh Torabi, finance journalist and host of the “So Money” podcast, cautions against borrowing too much and says it could be risky to borrow any more than 5 to 10% of your monthly budget. You can use a debt calculator to figure out what a reasonable loan amount, loan term, and monthly payment would be for your financial situation.
3. Check Your Credit Score and Credit History
Simply put: The better your credit score, the better rate you’ll receive. Personal loan interest rates for the most “creditworthy” borrowers can be as low as 4%, which is a quarter of what the average credit card APR is.
A good credit score, according to FICO, starts at 670 (out of 850). What appears on your credit report also matters. Do you make timely payments to your creditors each month? How much debt do you carry? This all determines creditworthiness and how much of a risk a lender may consider you.
Because of the COVID-19 pandemic, the three major credit bureaus (Equifax, Experian, and TransUnion) are offering free weekly credit reports at AnnualCreditReport.com through April 2021. Previously, under normal circumstances, you were entitled to one free credit report from each of bureaus every 12 months. If you see inaccurate information on your credit report, you can dispute it with the credit bureau.
If you have poor credit history (e.g., you’ve missed payments in the past or filed for bankruptcy), you may need to get a cosigner or put up collateral in exchange for a lower rate — two risky options you should consider as last resorts. To get on the path to creditworthiness, we recommend looking into credit counseling. Taking on any additional debt when you have bad credit can be an enormous risk and should be done only as a last resort.
4. Decide the Type of Loan You Need
Most personal loans are unsecured (don’t require collateral) and have fixed interest rates that depend on your creditworthiness, but that’s not the case for all. Some personal loans offer variable rates, require a cosigner or collateral that can be seized if you default on the loan, or have specific use cases (e.g., debt consolidation). Knowing what you want — and what you can realistically get approved for — will help when searching through the marketplace.
Fixed vs. variable rate
The majority of personal loans come with a fixed interest rate, which won’t change over the repayment period. The fixed-rate loan is advantageous if you prefer the consistency of fixed payments, though rates tend to be higher than variable-rate loans. You may prefer a variable-rate loan if you want to start at a lower rate, but the risk is that interest rates may rise and you would have to pay more per month over time.
Secured vs. unsecured
Most personal loans are unsecured, meaning they don’t require collateral for approval. However, putting up collateral (e.g., your house, real estate, car, or a bank or investment account) can help you get a better interest rate and make you a more attractive candidate for the loan, as it balances the risk a bank would be taking on. The downside is if you default on the loan, the lender has the right to seize your collateral.
Cosigner vs. no cosigner
Attaching a cosigner with an established credit history and good credit score can enhance your loan application and help you get a better rate, especially if you have poor or limited credit yourself. You will need to be 100% sure that you can pay off the loan, though. Missing loan payments would ding your credit and the credit of your cosigner, and the cosigner would legally be on the hook for the loan if you default.
5. Shop Around and Pick a Lender
The first offer is rarely the best offer. To get the lowest rate for your situation, you will need to contact multiple lenders. Take note of term lengths, interest rates, whether or not a cosigner or collateral would be required, and any fees (such as origination fees or prepayment penalties) that could take a chunk out of your loan.
Compare offers between your current bank (which could cut you slack if you are a solid customer), traditional brick-and-mortars, online banks, community banks, credit unions, and online lenders, such as Rocket Loans, LendingClub, and SoFi.
Some online lenders will run a soft credit check and offer prequalification (or pre-approval) on a personal loan. It’s no guarantee that you’ll get a loan, but it does make it easier to get a sense of whether you’ll be approved, as you won’t have to go through a hard credit check (which dings your credit score and can stay on your credit report for up to two years). To prequalify for a loan, you’ll need to have a good credit history, income, and a low debt-to-income ratio.
6. Submit an Application
Once you’ve selected what lender you want to work with, you’ll need to apply for the loan — even if you’ve gone through the pre-approval process. Many banks, credit unions, and lenders have an application process online, though some may require an in-person consultation.
The application will ask what loan amount you’re requesting and whether you’re applying with a cosigner or collateral. You’ll also need to provide your full name, date of birth, permanent address, email address, phone number, Social Security number, and self-reported information on your income, employment, and current debt. Later in the process, once you’ve received and accepted the offer, the lender will ask for proof (documentation) of the info you provide in the application.
7. Read the Contract
Loan terms will differ between lenders, so keep an eye out on these must-haves and nice-to-haves. If part of an offer is unclear, you are well within your right to ask for clarification or negotiate better terms.
APR: Annual percentage rate. Make sure it is clear in the offer if the APR is fixed or variable. The origination fee (if applicable) should be included in this percentage so you can understand the actual interest you’ll be paying per month.
Repayment period: When will you need to pay off the loan? Twelve months? Twelve years? Check the estimated monthly payment and see what portion of your budget it makes up. Torabi doesn’t recommend loan payments larger than 5 to 10% of your monthly budget.
Secured or unsecured: Will this loan require collateral for approval? Whatever you put up (whether it’s a bank account or a house), it can be subject to seizure if you default on the loan.
Origination fee: An up-front administrative or application processing fee paid when you receive the loan. Often between 1 and 8% of the loan, this fee is typically factored into the APR. Anuj Nayar, financial health officer at LendingClub, says any lender you work with should be up front about fees. “Other banks will say, ‘We’re not going to charge you a fee,’ but then they just charge you a high rate of interest,” he explains.
Prepayment penalty: Some lenders will charge you for paying off a loan early, so ask if this applies to your loan offer. You don’t want to be punished for wanting to get rid of debt.
Payment reporting to credit bureaus: Many lenders will report on-time payments to credit bureaus, which can offer a nice boost to your credit score.
Automatic withdrawals: See if you are able to automate monthly payments to your lender, so you never miss a due date. You may be able to get a discount by setting up automatic payments, depending on the lender.
8. Provide Documentation
If you’ve decided to accept the offer, you’ll need to provide information that proves you’re a safe investment — meaning, you’ll pay back the loan. Typically, lenders request information about you either in the application or through third-party companies, like credit bureaus. Here is what banks may request:
- Credit score
- Credit history
- Employment history
- Driver’s license, passport, Social Security card, or other form of ID
- Verification of address (e.g., ID, a piece of mail, lease, or utility bill)
Keep in mind you may be required to provide documentation or go through an additional verification process. It may be helpful to keep on hand W-2s, pay stubs, employer contact information, and other methods of verification.
The lender will run a hard credit inquiry to verify your credit history, so your credit score may be down a few points for a short period of time.
Once you’re approved for the loan, it can take anywhere from a few seconds to a week to see the personal loan funds via bank deposit. After the disbursement, the only step left is making sure you are budgeting appropriately and making payments on time until the loan is paid off.