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Personal loans are a popular way for many individuals to get funds, offering flexibility and quick access. As of Q4 of 2023, 23.5 million Americans had a personal loan, up from 22.5 million for the same period in 2022. The total outstanding personal loan balance in the US is $241 billion—an increase of 54 percent since the end of 2019. These statistics highlight the popularity of personal loans. However, is it right for you?
This article will field frequently asked questions about personal loans, clarify the process, and help you make informed decisions.
What is a personal loan?
A personal loan from a lender is money you can borrow with a fixed payment to finance large purchases, consolidate debt, invest in yourself, or cover emergency expenses. Interest rates, monthly payments, and repayment terms vary based on creditworthiness, income, and other factors. You can use it for any reason, such as consolidating debt, renovating your home, or dealing with unexpected expenses.
What are the types of personal loans?
Personal loans come in different types. The one you choose will depend on your circumstances and needs.
Unsecured
Unlike a car loan or home mortgage, a lender does not require collateral or security for an unsecured loan. The amount and terms you get will depend on your income and creditworthiness. In most cases, you can get the best deal if you have a high credit score and make enough money to handle the monthly payments comfortably.
Secured
With a secured loan, the lender will place a lien against something you own in exchange for borrowing money. You can use any physical or tangible asset as collateral, provided it has value, like a house or car.
The asset you commit for the loan gives the lender more certainty that you will repay the loan. If you fail to pay on a secured loan, the lender can dispose of your asset to recoup the unpaid loan balance.
You can qualify for secured loans more easily than unsecured ones and at lower interest rates because they carry a lower risk for the lender. Knowing precisely what you are promising and what you stand to lose is vital before you take out a secured loan.
Fixed-rate vs. variable-rate loans
Fixed-rate loans are where the interest rate remains fixed for that loan's life, regardless of the market interest rates. That will result in your payments being the same over the whole term. The viability of a fixed-rate loan will depend on the prevailing interest rate when you take it out and the duration of the loan.
On the other hand, a variable-rate loan is where the interest rate follows market changes. The interest charged is on the outstanding balance and linked to an underlying benchmark or index, such as the federal funds rate. Fixed rates remain constant, while variable rates can change over time.
How do personal loans work?
Although applying for a personal loan for first-timers can be intimidating, the process is straightforward. Let's walk through the critical steps and actions you can take ahead of time to make the process go more smoothly.
Many lenders have platforms where you can apply online, which is quick and convenient. However, traditional banks and other lenders may require you to come in person to apply for a loan. Regardless, the loan application involves giving your personal and financial information, like your name, home address, income, and employment details. The lender may also request you to provide additional documents, such as the following:
- State-issued ID
- Proof of residence
- Income documents, like payslips or bank statements
- Tax return
After you apply, wait for the results, which may arrive within minutes or in a few days. If your application is complete and error-free, you'll receive a decision faster.
If approved, the next step in applying for a personal loan is to review your final loan documents and then accept and sign them. Your loan documents will include important information such as the loan amount, interest rate or APR, loan term, and monthly payments. Within a few days of acceptance, you should receive funds in your bank account or check if you opt for that payment method.
When you apply for a personal loan, lenders will do a hard credit pull. The consequences may be a few points off your credit score, so you want to do it sparingly. Suppose you're shopping around with multiple lenders. Your applications will be treated as one credit inquiry if made within a 14-day period, reducing the effect on your credit score.
What are the requirements for a personal loan?
Getting personal loan approval comes down to a combination of several factors. These include your annual income, creditworthiness (credit score and history), and debt-to-income ratio. Lenders check your credit score to evaluate the risk they take with you as a borrower. A higher score means you are at a low risk for default, increasing your chances of approval and getting a lower interest rate.
Credit score requirements
The minimum credit score for approval for a personal loan may be as low as 560, but it varies across lenders. Most require a higher score.
Regardless of the minimum requirement, most lenders prefer borrowers with good or excellent credit scores. Still, some accept applications with bad credit but with limitations and at a premium. Your best bet is to know the rate you will get based on your credit. Some platforms, like SoFi, provide a way to get a rate estimate without doing a hard check.
Lenders typically consider the FICO credit scoring model, although some may also use VantageScore. Additionally, some lenders claim to consider a wide array of data points for approval, potentially including FICO or VantageScore.
Lenders typically put a premium on credit scores, determining your chances of approval for a personal loan and the annual percentage rate (APR) offered. People with excellent credit scores are more likely to qualify for a lower APR than those with poor ones. The average personal loan interest rate is 12.35 percent as of June 2024. However, anyone with a credit score between 630 and 689 might expect to pay around 20 percent.
High credit scores don't guarantee you'll qualify for a loan or get a low interest rate. Qualifying depends mainly on your credit history, score, income, and debt.
Income and employment verification
You’ll need to provide the lender with documents confirming the information you provided on your application. Some lenders may be able to do verification electronically, but most will ask you to provide the following:
Proof of identity: Lenders typically accept valid government IDs such as a driver's license, passport, Social Security card, or a state-issued ID. You can also present a birth certificate or certificate of citizenship.
Proof of address: Lenders want to confirm your verifiable address and where you've lived for the past few years. They may request copies of lease or rental agreements, utility bills, credit card statements, or property tax bills as proof of address.
Proof of Income: A lender wants to see that you can repay your current debts and the new loan. They typically require prospective borrowers to provide their employment history and current income as part of their application. Typical documents for income and employment verification include:
- Paystubs
- W-2s and 1099s
- Bank statements
- Employer contact information
If you are self-employed, you can provide bank statements, 1099 forms, and income tax returns instead. Some lenders also accept child support, social security, and other forms of income to be eligible for a loan.
Lenders set income criteria for borrowers to confirm their ability to repay a new loan. Each lender has its minimum income requirements. For example, SoFi requires prospective borrowers to have a minimum annual income of $45,000. However, it's common for lenders to keep their minimum income requirements private.
The majority of lenders offer secure online portals for submitting required documentation.
How should I evaluate a personal loan offer?
Properly evaluating loan terms and interest rates is crucial for choosing the right personal loan. Generally speaking, a reasonable interest rate on a personal loan is below the national average.
Although personal loan balances are at an all-time high, they are beginning to go down. Rates on 3-year fixed-rate loans averaged 15.57 percent between May 30 and June 7, 2024. That is down from 15.62 percent the seven days before and up from 14.14 percent a year ago. However, interest rates are still rising, causing lenders to tighten their lending criteria and choose low-risk borrowers.
Interest rate
A loan's interest rate dictates how much you'll pay the lender in interest for the loan term. It is a percentage of the principal amount outstanding in exchange for borrowing money and may be fixed or variable. However, unlike the APR, the interest rate does not include loan fees.
The APR is the total monthly cost you pay to borrow money, including fees, expressed as a percentage. It is the best way to determine how much your loan will cost you overall and a more accurate way to compare multiple loan offers. Suppose one loan package has some fees but a lower interest rate, and another has no fees but a higher interest rate. Comparing APRs should help you solve the mystery of which loan is less expensive.
Loan term
The loan term is the tenure or the time given to you to repay the loan. Generally, most personal loans offer terms between one and eight years. Typically, the shorter the repayment period, the higher your monthly payments. The upside is that you will pay off your loan faster and pay less interest.
Goals
Ultimately, choosing the right personal loan package will depend on your goals. Consider whether it will work for your situation when evaluating a loan offer. Answer the following questions to narrow down your options:
- Will the loan amount cover your needs?
- Can it help you achieve goals like paying off high-interest credit card debt?
- Can you afford the monthly payments without undue hardship?
- What is more critical: lower total cost or lower monthly payments?
Suppose two loans have the same repayment term and amount. You can compare the total cost apples-to-apples. Since the APR will include fees, look at it instead of the interest rate. With everything else being equal, the lower APR loan package should cost you less in the long term.
Sometimes, a loan with higher fees and APR may involve a more manageable monthly payment because of the longer loan term. Depending on your cash flow situation, you may take the lower monthly fee in exchange for paying more interest over time.
What is the prequalification process?
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You might have received emails that you were pre-approved for a personal loan. The reality is that you still have to apply for it. The beauty of prequalification is that it allows you to see potential loan offers without negatively affecting your credit score. It gives you an idea of the loan amount and interest rate you might qualify for without a hard credit check. It also gives lenders an idea of your creditworthiness and an estimate of the loan offer you might receive.
Getting prequalification, however, doesn't guarantee you will get a loan. Lenders will still need to verify your information before final approval. Below are the steps in the prequalification process.
Fill out the prequalification form
Most lenders allow you to fill out a prequalification form for a personal loan on their platform. You may be asked to provide personal information such as your name, contact information, date of birth, and Social Security number.
The form will likely ask about your employment, annual income, retirement, investment, and savings accounts. Finally, the lender will ask about the loan amount and intended purpose.
Because rates and terms vary, you should apply for prequalification with multiple lenders to compare offers. Once you submit the form, you should see the applicable loan terms within minutes.
Expect a soft credit check
Prequalifying for a personal loan in advance should not impact your credit score. When you submit a prequalification form, the lender's next step is to do a soft credit check. This type of check does not appear on the credit reports seen by a lender during the formal application process, so it will not harm your chances of approval.
If you receive an offer through prequalification, the lender will ask you to complete a full application. Prequalified offers typically indicate the amount you qualify for, the annual percentage rate, total interest costs, and anticipated monthly payments. The lender can modify the offer after you submit a formal application. You can reduce the likelihood of a modified offer by providing thorough and accurate information during prequalification.
If your application is declined, you should expect to receive an adverse action notice or letter. That will contain details about the credit agency that provided the report, the reasons for the denial, your current score, the contributing factors, and instructions for obtaining a free copy of your report. This information can be beneficial in swiftly improving your credit score and enhancing your chances of being approved for a personal loan.
What is the top benefit of personal loans?
Quick funding is one of the major advantages of personal loans, especially in emergencies. Over 60 percent of borrowers said their personal loan improved their financial situation, while 14 percent said it worsened.
You might have seen numerous online lenders touting that you can get your money in minutes. While that might not always be true, you can get it quickly if you qualify for a loan. Typical timelines for personal loan approval range from a few hours to a few weeks, depending on the lender and loan package.
Reputable online lenders such as SoFi pride themselves in a streamlined application process and quick disbursement of funds. However, fast doesn't mean sloppy. SoFi prioritizes applications with complete documents that meet eligibility requirements.
Personal Loans Can Save the Day
Personal loans are versatile financial tools that provide quick access to funds for various purposes. However, to make well-informed decisions, you must clearly understand the loan types available, the requirements for approval, and the attendant terms and conditions. Prequalification and expedited funding offer significant advantages when obtaining a loan.
Carefully researching and comparing the available options enables individuals to select the personal loan that best aligns with their financial requirements. Online resources and consultations with financial advisors can help you better understand the various personal loan options and their potential impact.
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