It is best to do a good bit of research in the financial world before you buy into the latest trending opinion about products or services. Consider personal loans; in certain circumstances, they can be a great solution but in other ways may be a concern to your long term financial health.
The reality about personal loans lies somewhere in the middle of those two extremes. In some situations, a personal loan is brilliant, and other times it is a terrible plan.
Breaking down the truth about personal loans should help you make smart and safe decisions about this type of loan.
What is a Personal Loan?
A personal loan allows you to secure funding for something important to you personally. Frequently, borrowers will use personal loans to pay for home renovations, pay off high-interest debts, make a significant purchase, or finance a wedding.
Typically, personal loans are unsecured. However, some lenders may ask for collateral to secure the loan. The secured loan may come with a lower interest rate than an unsecured loan.
7 Points You Need to Know
There are many positives associated with personal loans, and they are quite popular these days.
- Use the Money for Almost Anything – Some lenders may restrict personal loans regarding using the money to open a new business, pay for post-secondary education, or purchase a property. However, the list of potential uses is quite substantial.
- May Eliminate the Need for Collateral – Many personal loans are unsecured. This gives borrowers who are just starting or who have not accumulated many assets to qualify for a loan.
- Borrowing Limits Tend to Be Flexible – Your personal credit history plays a substantial part in setting the upward limits of your loan. However, someone with excellent credit may receive offers up to $100,000 on a personal loan. Your credit history will also impact your interest rate.
- Offer Competitive Interest Rates – If you take the time to prequalify with lenders, you will have a chance to see your interest rate options with a few financial institutions. This will help you make a sound decision when choosing a lender.
- Allow You to Pay Over Some Time – If you are facing an expensive car repair or covering the cost of a wedding, it can be challenging to come up with the money for upfront charges. A personal loan with a fair interest rate can take the stress out of tight financial situations. It is wise to use caution if your plans for a personal loan are discretionary wants. Remember, you will likely pay with interest.
- Personal Loans Make Consolidating Debt Easily – If your loan is used for debt consolidation, you will be able to worry less about making several payments each month. Additionally, your interest rate may be lower than the rates you are presently paying on credit cards.
- Personal Loans Can Help You Build Credit – Lenders report your payment history to the major credit bureaus. By repaying your loan reliably, you can boost your credit score. However, the opposite is true if you default on the loan or miss payments.
Three Reasons a Personal Loan Might be a Mistake
While personal loans have many positive aspects, some people can experience some of the potential problems that may accompany these loans.
- If You Are Using the Money for Wants and Not Needs – Only you can decide if Italian leather shoes or a week in Bali are needed. However, if you are using personal loans to finance discretionary spending that you really cannot afford, you are at risk of harming your credit score.
- You May End Up Paying High-interest Charges – Interest rates on some personal loans can be high. The rates vary by lender, and your credit score and history will play a big part in your interest rate. Also, be aware of variable interest rates. A loan that has a comfortable repayment amount today can suddenly become a burden if your rate goes up.
- You Could Be Hit With Fees and Penalties– Make sure you check the terms of your loan before signing on the dotted line. Find out if you will have prepayment penalties or if your lender is charging an origination fee.
Questions to Ask Yourself Before Applying
When it comes to financial matters, the last thing you should do is approach the situation casually. Your application for a personal loan will go on your credit report and influence your credit score, even if you are turned down.
- How Much Do I Need to Borrow? The majority of lenders have a minimum amount required for a loan. Some minimums may be as low as $500. However, the typical minimum is usually between $1,000 and $2,000. Your maximum amount will be determined by your lender based on your financial situation.
- Can I Afford Another Monthly Payment? The term ‘afford’ is relative. However, looking at a standard debt to income ratio can help. While this is typically used to help determine worthiness for home loans, the formula will show you where you stand financially.
Add your monthly expenses and divide by your monthly income.
For our example, $2000/$5000=0.40 in this example the DTI is 40 per cent. Most lenders consider this a high debt to income ratio. Typically, 10% or lower is excellent, and up to 20% is still good. Beyond the 20 % mark, adding more debt may cause you to struggle with repayment.
- Do I Have Other Choices? In some cases, you may be able to find favourable terms with a low-interest credit card or by borrowing from a friend or relative.
- Do I Have a Reasonable Plan? Knowing the what, why, and how of your finances is vital to maintaining financial health. Before you apply for a personal loan, understand your rationale. Are you doing a home improvement project to add value to your home? Is this loan to pay off other higher-interest loans? Or are you planning a grand holiday that you will spend years paying off with interest?
Six Questions You Should Ask Before You Sign
Before you agree to take on a personal loan, there are a few questions you should ask your lender.
- Is My Loan Secured or Unsecured? If your loan is secured, you will need to provide some form of collateral when you sign. With an unsecured loan, your lender determined that you can repay the loan and do not need to offer an asset as a way to guarantee your repayment. In some cases, an unsecured loan may have a higher interest rate than a secured loan.
- What Is My Loan Repayment Period? You will want to be clear about how much time will elapse between your first repayment instalment and the final payment on your loan.
- What Type of Interest Rate Comes With This Loan? You should know if you are dealing with a fixed interest rate, where the amount of interest you pay is the same throughout the life of the loan. Or if your loan has a variable interest rate. Meaning your required monthly repayment amount may increase or decrease based on extraneous factors.
- Am I Being Charged Fees? Lenders differ in the fees they charge. A typical fee you may encounter is the origination fee. This is a one-time upfront fee that comes from your loan amount. Typically, it is between one and five per cent, but the percentage may vary. It works like this: if you are getting a $10,000 loan with a five per cent origination fee, you will receive $9,500, and $500 will immediately return to your lender as the origination fee.
- Is There a Penalty for Paying Off My Loan Early? Be sure you know about any prepayment penalties associated with your loan. Some loans will charge if you pay your loan before the agreed-upon repayment period.
- How Soon Will the Money Arrive? You will want to have a timeframe for the arrival of your money. Each lender varies.
Conditions Where a Personal Loan May be Right for You
While over-generalising is not a good idea, the following circumstances indicate that a personal loan may be right for you if,
- Your credit score is high. Approaching a lender with a high credit score usually helps you qualify for a low-interest rate.
- The debt you will take on will not become a burden. If there is room in your budget for a new monthly payment, a personal loan can work.
- Your plan for the loan is to consolidate multiple, high-interest debts.
- You know that you will not qualify for a low-interest credit card.
- The personal loan will help you finance a project that adds value to your home.
Whether you are interested in learning more about personal loans or another financial transaction, Quantum Finance can help. Contact us to speak with one of our financial experts who can provide answers to your questions along with sound financial guidance.
** Please Note**
The material presented here is for informational use only. It is not intended to be binding financial guidance and should not be used as a replacement for an individual consultation with an experienced professional.