In general, loans are not all that complicated. You get a mortgage to help you finance your property, car loans for that new car, and student loans so that you can study. If there is one area of the financing arena that it’s a little murkier, it’s personal loans.
These more all-purpose loans are not as clearly defined as the others. You could ostensibly use this loan to pay for just about anything. Before you rush out and apply for one, however, let’s take a closer look to see how they work.
What is a Personal Loan?
A personal loan is typically an unsecured loan. Now, depending on the amount you’re applying for, a banker might ask you to put up some form of collateral, but most of the time, this is not necessary.
Applying for the loans is, therefore, a pretty simple process. There are many different lenders to choose from, and you can even apply online. We’d recommend shopping around a bit first to get the best rates, though.
The loan could be used to fund your wedding, your dream vacation, or to buy three hundred pairs of socks. You choose.
How do They Work?
Despite the lack of clarity about the purpose of personal loans, it’s easy to understand how they work. You apply for the loan and wait to see if it’s approved. If you don’t qualify for the amount you’ve applied for, you may receive a lower counter-offer.
Either way, you’ll be told exactly what interest rate and fees you’re letting yourself in for in the future. You’ll then be asked to confirm that you want the loan. The money is then paid into your bank account, and you’ll start repaying it monthly on your next payday.
If you’ve got a high credit score, you’ll get a reasonable rate. If your credit is terrible, it will be harder to get the loan at all, and you’ll pay a higher interest rate. The higher the risk you pose, the more it’s going to cost you to borrow money.
The interest rate you pay could be fixed or variable. A fixed interest rate will usually be fixed slightly higher than the standard rates. The advantage is that it will never change throughout the term of the loan.
A variable interest rate will start lower. If rates go up, your rate will as well. If rates decrease, so will your rate.
Make sure you understand how the interest works on your loans.
Here are some questions you need to be answered before you accept the loan:
- What interest rate will I pay?
- What is the annual interest rate? (Or, how much will you pay in interest per year?)
- How much is the admin fee for the application?
- What term have I been approved for?
- Is the interest variable or fixed?
- Are there any extra charges I should be aware of? (You might have a monthly admin fee or some required insurance)
- Is there a penalty if I settle the loan early?
- What are the fees for paying late?
When do Personal Loans Make Sense?
Credit can be a valuable tool when used correctly. A personal loan can make more sense than a credit card. The interest is lower, and you don’t have access to revolving credit. The rates are, however, higher than secured loans.
So, if you can draw down the money from your mortgage, that could be a better option. That’s only true if you pay the money back over the same term you would have the personal loan.
The other advantage that a personal loan has over other types of loans is that it can be used for what you like. If you’d like to consolidate your debt at a better interest rate, for example, it could be a useful tool.
That said, you have to ensure that your repayments are made over the same period as the initial payments.
If you have a credit card budget account to pay off over six months and consolidate the debt, that portion needs to be paid off over six months to see interest benefits.
When is a Personal Loan a Bad Idea?
The problem with personal loans is that you can use the money for anything that you like. It might, therefore, be tempting to take out a loan and use the cash to splurge. This is seldom a smart move financially.
Buying Things, You Don’t Need
If you’re using the money to buy the latest designer outfit or something that’s not going to last six months, it’s not such a good idea. A personal loan should be looked at as more of an emergency resort.
Sure, you could go and get that designer bag now, but what happens if, in a few months, your car breaks down or the plumbing in your house fails?
A far better way to go about this is to set up a discretionary fund for yourself. This is money you can spend on whatever you like. It should be set aside after you’ve paid your bills and saved some money.
When that money is finished, that’s it. It’s time to go into lockdown mode when it comes to splurging. This strategy may seem a little boring, but it’s a great way to stop you from spending money on things that you don’t need.
Improving Your Credit
There are a couple of schools of thought when it comes to improving your credit score. If you have no credit whatsoever, then a small personal loan that you repay quickly could assist you in building your score.
If you already have credit, it’s better to work at repaying what you’ve got instead. Remember that the number of credit accounts that you have has an overall impact on your credit score. So, even if you’re paying that loan on time every month, it could hurt your score if you have too much other debt.
The same goes for credit cards. One or two could make sense, but more than that is overkill.
A Once-In-A-Lifetime Purchase
Maybe you want to get the biggest, baddest, home stereo system. Maybe you want to hop on a plane and see the pyramids. Or maybe you want to pay for your dream wedding. Not one of these is a good reason to get yourself into debt.
Sure, that trip to Egypt is a great experience, but how much will you enjoy having to pay it off over the next five years? Instead, try to save your money and pay cash as much as possible.
Issues with Personal Loans
Okay, you’ve weighed your options and decided that the personal loan is the way to go. What are some red flags that mean you should find a new lender?
- Being charged fees for paying early. Some companies charge you an early settlement fee so that they don’t lose out on the interest they would have otherwise. Run from these companies
- You’re being told that you have buy insurance with the product. Why should you? If the amount is large, then sure, the company might need some assurances, but they should let you bring in your insurance policy for this
- Loan companies that will lend to you even if you have bad credit. These seem like a good idea when you need a lifeline, but they’re going to gouge you on the interest. Even if the rate appears okay, there will be extra charges. You are better off going through credit repair.
Personal Loans Final Thoughts
Personal loans have a place. We’re not saying that you should never take out a personal loan. What we are saying, though, is that you should always carefully consider why you’re taking it out. Used smartly, the loan might be a good thing, but any credit can land you in hot water. Assess your needs, find a good lender, and you’ll be in good shape.