How Do Personal Loans Work?

Date posted: Sept. 10, 2015

A personal loan is a sum of money issued to a borrower by a lender for any number of purposes. A personal loan is a great way to consolidate debt, take a vacation, purchase a boat, or even pay college tuition.

The Credit Check  

First, when you ask a lender for money, that lender will perform a credit check. Often, they will retrieve your FICO score to determine your level of responsibility with credit. If you have a high FICO score, this demonstrates outstanding responsibility and you will qualify for larger sums of money with low interest rates and flexible repayment terms. On the other hand, if you have a low score, you will be eligible for smaller sums of money with higher interest rates. If your score is very low, many banks may deny you a loan altogether. If you have no credit, you may have trouble with getting a personal loan, as well. Start by asking for a small loan, and then pay it off according to the terms.

Determining Your Interest Rates

Because your credit rating often determines your interest rate, this varies significantly. Individuals with extremely good credit may enjoy interest rates as low as 3% to 5% on their personal loans. On the other hand, individuals who have bad credit may pay as much as 16% to 30% interest. Although it may seem counterintuitive to charge someone who has had past trouble repaying debt a higher interest rate, banks do this to mitigate the risks they encounter by lending to someone who may not pay them back as promised. For the same reason, individuals with no credit history at all often pay high interest rates until they have established their FICO scores.

Will You Need Collateral or a Co-Signer?

In some situations, a bank may not lend to someone who has bad credit unless that individual can put up collateral or bring a co-signer. Collateral is essentially valuable property that the bank holds until the borrower repays the loan. For example, a borrower may put up the title to a $10,000 boat as collateral on a $7000 loan. After repaying the loan, the borrower receives the title to the boat. If the borrower defaults on the loan, then the lender has the right to take possession of the boat and resell it to recoup losses. On the other hand, with a co-signer, the bank relies on the co-signer's good credit and promise to make good on the payments if you default.

Understanding the Repayment Terms

After your approval for a personal loan, you should review all of your loan documents very carefully. These include all of the terms for repayment, including the total number of monthly payments, the amount of each monthly payment, the interest rate, the total amount of interest you will have paid at the end of the term, and more. All of this is very important because it gives you a broader sense of the amount of money you will pay in the end. Before you sign, make sure that you can agree to the conditions throughout the loan term.

Personal loans are quite simple in nature, and the process takes anywhere from a few days to a few weeks to complete from the time you apply until the time you receive the funds. Although this is not always the best method for getting quick money, personal loans are great for consolidating debt and making large purchases.

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