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How Do Personal Loans Work?

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Credit cards aren’t the only option when it comes to financing purchases or consolidating debt. Personal loans are a popular choice thanks to digital offerings that make it easy to apply and get approved.

But before you sign on the dotted line, you have to make sure a personal loan is right for you. To do that, you have to understand the inner workings of this borrowing tool.

You don’t want to end up with an expensive loan you didn’t understand or one you’re ill-equipped to pay back.

Rewind ten years when consumers had fewer options when it came to borrowing money. They could use a credit card, which usually meant paying high interest rates, or apply for a bank loan, which was hard to get without top-notch credit. The 2008 recession changed that.

With little in the way of consumer lending being done by the banks, a crop of financial technology startups (or FinTechs) emerged to offer consumers personal loans. Using different underwriting data and algorithms to predict risk, they created a market that’s now booming.

According to TransUnion, the credit scoring company, unsecured personal loans reached $138 billion in 2018, an all-time high, with much of the growth coming from loans originated by FinTech companies.

The average loan size in the fourth quarter of 2018: $8,402. Fintech loans account for 38% of the overall activity in 2018; five years ago, it was just 5%.

How Personal Loans Work

Personal loans come in many flavors and can be secured or unsecured. With a secured personal loan, you have to offer up collateral or an asset that’s worth something in case you can’t pay the money you owe back.

If you default, the lender gets that asset. Mortgages and auto loans are examples of secured debt.

With an unsecured loan, the most common type of personal loan, you aren’t required to put up collateral. If you don’t pay back the money the lender can’t garnish any of your assets.

That’s not to say there aren’t repercussions. If you default on an unsecured personal loan it will hurt your credit score, which raises the cost of borrowing, in some cases dramatically.

And the lender can file a lawsuit against you to collect the outstanding debt, interest and fees.

Unsecured personal loans are typically used to finance a big purchase (such as a wedding or vacation), to pay down high-interest credit card debt or to consolidate student loans.

Personal loans are issued as a lump sum which is deposited into your bank account. In most cases, you’re required to pay back the loan over a fixed period of time at a fixed interest rate. The payback period can be as short as a year to as long as ten years and will vary from one lender to the next. For example, SoFi, an online lender, offers personal loans with terms between three and seven years. Rival Marcus by Goldman Sachs offers loans with terms from three to six years.

Borrowers who aren’t sure how much money they need can also take out a personal line of credit. This is an unsecured revolving line of credit with a predetermined credit limit. (In that respect, it’s a lot like a credit card.) The interest rate on a revolving line of credit is typically variable, meaning it changes with the prevailing interest rate in the market. You only pay back what you draw down from the loan plus interest. Lines are commonly used for home improvements, overdraft protection or for emergency situations.

Your Credit Score Dictates the Cost to Borrow

When weighing whether a personal loan makes sense, you have to consider your credit score. It’s a number ranging from 300 to 850 that rates the likelihood of you paying back your debt based on your financial history and other factors. Most lenders require a credit score of 660 for a personal loan. With credit scores lower than that, the interest rate tends to be too high to make a person loan a viable borrowing option. A credit score of 800 and above will get you the lowest interest rate available for your loan.

In determining your credit score a lot of factors are taken into account. Some factors carry more weight than others. For example, 35% of a FICO score (the kind used by 90% of the lenders in the country) is based on your payment history. (More FICO facts are here.) Lenders want to be sure you can handle loans responsibly and will look at your past behavior to get an idea of how responsible you’ll be in the future. Lots of late or missed payments are a big red flag. In order to keep that portion of your score high, make all your payments on time.

Coming in second is the amount of credit card debt outstanding, relative to your credit limits. That accounts for 30% of your credit score and is known in the industry as the credit utilization ratio. It looks at the amount of credit you have and how much is available. The lower that ratio the better. (For more, see The 60 Second Guide To Credit Utilization.) The length of your credit history, the type of credit you have and the number of new credit applications you have recently filled out are the other factors that determine your credit score.

Outside of your credit score, lenders look at your income, work history, liquid assets and the amount of total debt you have. They want to know that you can afford to pay the loan back. The higher your income and assets and the lower your other debt, the better you look in their eyes.

Having a good credit score when applying for a personal loan is important. It not only determines if you’ll get approved but how much interest you’ll pay over the life of the loan. According to ValuePenguin, a borrower with a credit score between 720 and 850 can expect to pay 10.3% to 12.5% on a personal loan. That increases to between 13.5% and 15.5% for borrowers with credit scores from 680 to 719 and 17.8% to 19.9% for those in the 640 to 679 range. Under 640 and it will be too cost prohibitive even if you can get approved. Interest rates at that level range from 28.5% to 32%.

There’s A Trade-Off
Personal loans can be an attractive way to fund a big purchase or get rid of credit card or another high-interest debt. Terms are flexible, allowing you to create a monthly payment that fits into your budget. The longer the term, the smaller the monthly payment.

But there’s a trade-off. You pay interest for a longer period. What’s more, the personal loan interest rate increases the longer the term of your loan.

Take a personal loan from SoFi as an example. On a $30,000 loan, a borrower with the best credit will pay 5.99% for a three-year loan. That jumps to 9.97% for a seven-year loan. At Citizens Financial Group the interest rate is 6.79% for a three-year loan and 9.06% for a seven-year loan. At LightStream, a unit of SunTrust Bank, the interest rate on a three-year loan starts at 4.44%. For seven years, expect to pay 5.19% in interest.

In addition to the interest rate, some lenders charge a loan origination fee, which is the cost to process your application. That can make the cost of borrowing more expensive. The good news: origination fees are starting to disappear, particularly on digital platforms. Some of the online lenders that don’t charge borrowers origination fees include SoFi, LightStream, Marcus By Goldman Sachs and Earnest. All require at least a 660 credit score. When shopping for a personal loan, compare the annual percentage rate or APR. It includes the interest rate and fees to give you the full picture of how much you’ll pay.

If you have a good credit score, a personal loan is a reasonable option to finance a big purchase or consolidate debt. If your credit score is less than stellar, paying a higher interest rate may be worth it if it means getting yourself out of even higher rate debt. Before you make the leap do the math.

Consider the interest rate, fees and terms. If you end up paying thousands of dollars to consolidate your debt, it’s not the best option for you.

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