When you don’t have the money you need, what do you do? Increasingly, people are turning to personal loans. Some 24 million Americans are expected to take out a personal loan this year, and according to TransUnion, the number of people with personal loans has grown 18% since 2013.
Traditionally, folks turned to credit cards for a solution to a cash crunch. But they are tired of high, variable interest rates and balances that took forever to pay down because they continued to pile on more debt.
Personal loans aren’t new, but for many, they’ve become the go-to product when they get in a jam. "They are using these loans to refinance credit card debt, pay medical bills, a vacation or even to start a new business," says Priyanka Prakash, a financial specialist with FitBizLoans.com.
What are the advantages?
Personal loans can be taken out for any reason. Often you don’t have to tell the lender how you intend to use the money. You can typically get anywhere from $500-$25,000 and more. A personal loan is "unsecured", meaning you don’t have to borrow against something valuable, like a house, say with a home equity line of credit or loan.
"There is little documentation needed, which means the processing time is quick – usually within 24 hours of applying," says David Harrison, co-founder of Los Angeles Legal Funding.
But that said, you still must qualify. "The main criteria are credit score and income. You should have a FICO score of at least 620-640 and have stable income. Some lenders will check non-traditional factors such as GPA if you’re a recent grad," points out Prakash. The lender will look for a high income to debt ratio.
Another feature that makes these loans attractive is that there is typically a fixed payment and fixed interest rate, unlike with credit cards that have variable rates.
Know what you’re getting into
Personal loans sound promising when you’re in a pinch, but there are a few things to consider.
"Many people misunderstand that personal loans are intended for short-term uses, such as emergency car repairs, or a new boiler in their home. The fees and interest rate that may be charged, over time, may not make the loan worthwhile.
While the interest rate charged is likely better than a credit card, it’s typically not as low as a home equity loan, and there’s a shorter payback period, which can make the minimum required payment higher, points out Chris Dervan, senior vice president and product manager in consumer lending at PNC Bank. "Once the loan is repaid, you can’t borrow again without a new application, unlike with a line of credit."
It’s important too, to understand your cost of borrowing, not just your interest rate. "The cost of borrowing is much more important," explains Parvesh Benning, a wealth and estate advisor with The Annex Financial Group.
Be clear about all fees and terms. "Some people don’t understand that a pre-payment penalty could apply to the term of the loan as an origination fee," says Pam Webb, a certified credit counselor with Transformance, a non-profit consumer credit counseling service.
Often banks will offer personal loans to people with CDs who need cash, but don’t want to close their CD early and get hit with an early withdrawal penalty. Do the math. Figure out if the interest you would pay for the loan would be more than the cost of the early withdrawal penalty.
There is an advantage to talking with your lender about what you intend to use the money for. "Sometimes better rates are available for specific purposes, or you may determine that a line of credit is a better option than an installment loan if, for example, you anticipate being able to repay the borrowed amount quickly, but wish to be able to borrow again if the need arises in the future," says Dervan.
Set yourself up for success
Before applying, take stock of your finances to ensure you can afford the loan. Research your options, including online lenders. Many credit unions and community banks offer favorable terms on personal loans, says Levar Haffoney, a principal with Fayohne Advisors. Have basic personal and financial information ready when you apply.
Finally, says Ryan Bailey, head of consumer deposits, payments and non-real estate lending at TD Bank, "If you’re using a personal loan to pay off other debt, such as credit cards, don’t continue to use them and accumulate more debt."