What is a personal loan? Flexible financing you can use for everything

  • A personal loan is money that you receive from a bank, credit union, or online lender and repay with interest over time.
  • Personal loans are installment loans that are generally unsecured and may have fixed or variable interest rates.
  • Unlike other forms of financing, personal loans can generally be used for just about anything.
  • Learn more about personal finance coverage »

Credit card, mortgages, auto loans, and student loans are all common forms of financing that you have probably heard of or even have experience with. But you may be less familiar with personal loans.

What sets personal loans apart from other loan products? And when should you consider taking out a personal loan? Here’s what you need to know about personal loans and when they might be a good financing choice.

What is a personal loan?

A personal loan is money you borrow from a bank, credit union, or an online lender that you pay off with interest over a specified period of time. Many lenders offer personal loans at a fixed rate (the interest rate remains the same throughout the life of the loan) or variable rate (the interest rate is subject to change during the life of the loan). The interest rates on personal loans vary depending on the applicant, depending on your credit.

contrary to credit card, which use revolving credit, personal loans are installment loans, like mortgages and auto loans. In other words, all the money is issued up front and you pay off the loan with fixed installments over a predetermined loan period.

Another feature that sets personal loans apart is that most of them are unsecured (like credit cards), which means you don’t need to post any collateral against the loan. Average interest rates on personal loans tend to be higher than secured loans like mortgages and auto loans, but lower than interest rates on credit cards.

How to use a personal loan?

Flexibility in the use of funds is one area where personal loans really shine. Most installment loans are very specific about how the funds are to be spent. Mortgages should be used to purchase a home, student loans for education, and auto loans for the purchase of the car.

But personal loans usually do not come with such restrictions. Borrowers can generally use the funds for just about anything they want. To give a few examples, you can use a personal loan to:

  • Consolidate debt
  • Renovate your home
  • Start a business
  • Pay the funeral expenses
  • Cover moving expenses
  • Finance your wedding expenses
  • Pay an emergency expense (such as an unexpected medical bill)

Whenever you are considering taking on debt, you have to weigh the pros and cons. By taking out a loan instead of saving to pay cash, you will end up paying more overall due to interest charges. But if you absolutely need the cash now, a personal loan can help cover a wide range of expenses.

Who is eligible for a personal loan?

Your eligibility for a personal loan and the interest rate offered to you will depend on two main factors: your credit score and your debt to income ratio.

Credit score requirements

Each personal lender is free to set their own credit score requirements. But according to FICO®, a score greater than 670 is considered “good”, a score above 740 is “very good” and a score greater than 800 is considered “excellent”. If your credit score is below 670, you may still be eligible for a personal loan.

But you are unlikely to qualify for the best rates. If your personal loan application is rejected due to your credit score, you may be able to find approval by adding a creditworthy co-signer to your application. Or if you have assets that could be used as collateral, you can try applying for a secured version of a personal loan. (And while you are applying for a loan, you might want to work on improve your credit score for the future.)

Personal loans have wide ranges of interest rates. Depending on the lender you choose, a good credit score might qualify for a rate below 5%, while less qualified borrowers might receive an APR above 30%.

Debt-to-income ratio

Your debt-to-income ratio (DTI) is obtained by dividing your total monthly debt payments by your monthly income. If you spend $ 500 on debt repayment each month and have a monthly income of $ 2,500, your DTI is 20% ($ 500 / $ 2,500 = 0.20).

According to Wells Fargo, you are “good looking” if your DTI is below 35%. The bank says borrowers with a 36% to 39% DIT are in the “Opportunity to Improve” category, while borrowers with a DTI over 50% should “Take Action” because they are likely to have limited loan options.

When is a personal loan a wise choice?

First, if you need several years to pay off the money you borrow, a personal loan might be a good option. Even if you could benefit from a 0% APR credit card (which gives you an introductory period during which you won’t owe interest on your balance, which provides a good opportunity to pay off debt), promotional periods on these cards usually don’t last longer than 18 months . If you need more time to pay your money back, a personal loan might be better suited.

Second, a personal loan might be a good choice if you don’t have equity in your home and want to finance a major renovation. Pay for home improvements can be a smart use of personal loan funds because renovations could increase the value of your home. But if you have equity to exploit, a Home Equity Loan or Home Equity Line of Credit (HELOC) could offer lower rates.

Finally, the fact that a personal loan can be spent on just about anything could make it the right choice for anyone who needs to cover an expense that is unrelated to their home, car, or education.

Do you think a personal loan is right for you? Check out our step-by-step guide to getting a personal loan.

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