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You may consider taking out a personal loan for a variety of reasons, including completing a home improvement project, making a major purchase, covering educational expenses, or paying an old bill that is accruing interest. In some cases, it can be quicker to take out a personal loan than a home equity loan, and you may not have enough equity in your home for a home equity loan in the first place.
Before you sign on the dotted line, however, there are a few things you should know.
What is a personal loan?
Personal loans are known as “unsecured” debt because they are not backed by collateral, such as your home or car, as is the case with a mortgage or auto loan, respectively. Lenders will use your credit score to help determine whether to give you a personal loan and at what interest rate. Depending on your credit history, the interest rates on personal loans can be higher than secured loans, so you may want to consider personal loans only for expenses you intend to pay off quickly.
Personal loans aren’t like credit cards, which are revolving loans. Credit card loans and other revolving loans have no fixed payment term and often have a fluctuating interest rate. Rather, personal loans are a type of installment loan. Installment loans have a fixed repayment term, usually two to five years, and often carry a fixed interest rate. You’ll receive a lump sum up front and then pay the money back (plus interest) in regular monthly installments.
Tip: If you’re taking out a personal loan, look for a fixed-rate agreement. While most personal loans have a fixed term and interest rate, there may be exceptions, so be sure to read the fine print.
Your credit score will determine the affordability of a personal loan
In general, your Equifax credit score ranges from 280 to 850, It’s an educational score—the score you see may differ from score a lender sees. A “very good” credit score ranges from 725 to 759, whereas 760 to 850 is considered “excellent.” The higher your credit score, the more affordable your loan may be. For example, one personal loan advertised on Bankrate.com carried an interest rate of 6.9 percent, which is several percentage points below the average credit card interest rate (last reported by the Federal Reserve in August as 11.8 percent).
But for borrowers with credit issues, the interest rate on a personal loan may be the same or more than the interest rate on a credit card. The average interest rate for a personal loan was 10.74 percent in October 2014, which is about the same as the average interest rate for a credit card. Some personal loans may even carry interest rates as high as 35 percent.
A high interest rate could result in large monthly payments, which can become unaffordable and cause you to make late payments or to miss payments completely. This may affect your credit score, and missed payments could remain on your credit file for up to seven years.
Tip: While you will want to shop around for the best interest rates available, be sure to compare the total cost of the loan, not just the interest rate, and speak to different lenders. Also bear in mind that a low interest rate could be an indicator of additional fees and conditions.
The potential risks involved with a personal loan.
Unlike a credit card, which you can pay off over an undetermined amount of time, a personal loan must be paid off in a fixed amount of time. This can mean you will be paying off the debt faster, but it can also pose problems if the loan isn’t paid off within the loan term. Because the loan isn’t secured by any property, if you don’t pay back the loan, the lender could take you to court and sue you. In addition, paying off your personal loan too early may result in extra fees. Some personal loan agreements include prepayment penalties if you pay off your loan before a certain date.
Finally, be wary of scammers who use false advertising to lure you into a fake loan agreement. One example is a so-called “advanced fee” loan, where you pay an advanced fee for a loan you never receive. Once you wire the money, it’s gone—along with some of your sensitive personal information.
Tip: Many credit unions have alternative programs that provide loans at low prices to people with poor credit scores. Additionally, credit unions are not-for-profit entities, so they may be able to charge lower interest rates than other banks.
If you qualify, a personal loan can be a great way to finance your expenses at a low cost, as long as you don’t get a larger loan than you need. However, before you consider taking out a personal loan, you may want to practice good credit habits to make sure your credit score is the best it can be. Improving your credit score may increase your chances of getting a loan with a lower interest rate.
Diane Moogalian is vice president of operations for Equifax Personal Solutions. Prior to joining Equifax in 2007, Diane held several strategic roles with leading financial services companies. Diane graduated from the University of Richmond with a Bachelor of Science in Business Administration (Marketing and Economics) and earned a Certificate in International Business from Virginia Commonwealth University.
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