Personal loans 101: How they work and who can qualify for them

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Personal loans can help finance a home renovation project.

• Unlike credit cards, personal loans offer a fixed interest rate, fixed repayment term, and fixed monthly payment.
• Personal loans can be used for debt consolidation or major home remodeling projects.
• Most personal loans are unsecured, meaning you don't have to put down collateral to borrow money. 
• Read on to learn more.

When you need cash, there are several reasonable ways to get it.

You may be able to get a small loan from family or friends, and you can always apply for a credit card. But, there's another option to consider that comes with certain advantages - and that option is a personal loan. While personal loans have gotten a bad rap, they can offer a predictable way to borrow money.

It all starts with how personal loans work. Unlike credit cards that charge variable interest rates and come with fluctuating payments that vary depending on how much you spend, personal loans let you borrow a predetermined amount of money with a fixed interest rate and a fixed repayment period. They also come with a fixed monthly payment you can agree to ahead of time, which makes budgeting for your loan a whole lot easier.

Personal loans can also come with a low interest rate depending on your credit worthiness. Where the average APR on a credit card is now over 17%, interest rates on personal loans start at around 4% APR for consumers with good or excellent credit.

Keep in mind that we're talking mostly about unsecured personal loans for the purpose of this article. While unsecured personal loans don't require any collateral, another type of personal loan known as secured loans do require collateral in order to borrow. Secured loans may come with lower interest rates since you are securing your loan with an asset such as a car, but not everyone wants to put up collateral in order to borrow money.

To summarize, here are the most important details you need to know about unsecured personal loans:

• You borrow a fixed amount of money.
• You get a fixed interest rate, a fixed monthly payment, and a fixed repayment period.
• Most personal loans are unsecured, but it is possible to get a secured loan.

Why do people take out personal loans?

While you can take out a personal loan for any reason (or no reason at all), these loans are popular for consumers who need to borrow money for a specific reason. Let's say you want to remodel your kitchen but don't have the $30,000 the project requires or enough home equity to qualify for a home equity loan or home equity line of credit (HELOC). In that case, a personal loan could offer the money you need for your project provided your credit was good enough to qualify.

Personal loans are also popular for debt consolidation, and it's easy to see why. Imagine you're a consumer with high interest credit card debt that's sucking your budget dry every month. A personal loan could help you consolidate that debt at a lower interest rate while securing a predictable monthly payment and a set payoff date that doesn't change.

Here's an example of how this could work: Imagine you have $10,000 in credit card debt with the average credit card APR of 17%. If you paid $250 each month, you would pay a total of $14,862 for 60 months (including principal and interest) before your balance was paid off. If you were able to consolidate that $10,000 balance at 5% APR and make the same $250 monthly payment, however, you could become debt-free in 44 months for a total cost of $10,962. 

Other reasons consumers get personal loans are nearly limitless, but can include:

• Borrowing money for a car
• Paying for higher education
• Paying for important home repairs
• Covering surprise bills and expenses

How to find the right personal loan

When it comes to shopping for a personal loan, you are better off comparing several lenders in terms of their rates, fees, and fine print. You'll obviously want to choose a loan with the lowest interest rate you can qualify for, but fees matter, too.

Some personal loan companies charge an origination fee that can range from 1% to 8% along with application fees and other fees. However, the highly competitive nature of the personal loans business means that many personal loans come entirely free of fees for consumers who qualify.

It's important to take into account fees associated with a personal loan, to make sure it doesn't make the total cost of your debt higher in the end. Your best bet is shopping around with several lenders to find an option that makes sense for your budget and your needs.

As you compare personal loan companies, you'll want to look for:

• A lender that offers competitive interest rates
• No fees or minimal fees
• A monthly payment and loan term you can afford

How can you qualify for a personal loan?

While some lenders will loan you money with a credit score in the 500's, you may need to put down collateral to qualify. At the very least, you'll pay a much higher interest rate for a personal loan.

Most lenders list a minimum credit score to qualify on their website, with many drawing the line at 670 or 680. With a credit score below what is considered "very good credit," or 740, however, you will likely pay a higher interest rate.

In addition to checking your credit score, loan companies will also need proof of employment and ability to repay in order to determine eligibility. They will also check your debt-to-income ratio to make sure you haven't borrowed more than you can feasibly pay back.

The bottom line

Personal loans offer a fixed repayment term, fixed monthly payment, and fixed interest rate. They may also come with fees or high interest rates for those who do not have a good credit score.

Make sure to get your credit in good shape before you apply if you want a loan with the best rates and terms. Like other financial products, compare offers from many lenders before making a decision. 

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