If you want to use a personal loan to overcome a financial difficulty or consolidate your debts, you are not alone. According to research by Bankrate, the average consumer had personal loan debt of around $16,458 in 2020. Before you go ahead with borrowing the funds you need, you need to compare loan types available.
What is a personal loan?
A personal loan is a borrowing product available from a bank, credit union, or online lender. It is commonly used to cover a financial emergency, make home improvements, or consolidate debt. Most personal loans are disbursed in a lump sum and payable in installments over a specified period, usually between one and seven years.
Expect to pay between 4-36% interest, depending on your creditworthiness and the loan product you select.
Types of personal loans
There are an assortment of personal loan options to choose from, and you’ll get a variable or fixed interest rate.
Secured Personal Loans
Secured personal loans require you to put up an asset that acts as collateral. For example, you can take out a loan on your vehicle, which is called a title loan.
While this might be an ideal option if you have a lower credit score and assets to put up as collateral, there is a downside. If you are behind on loan payments, the lender could seize your property and sell it to recover what is owed to them.
Unsecured Personal Loans
These loan products do not require collateral to be approved. Plus, you’ll have quick access to funds without putting your assets at risk.
Unsecured personal loans are best for borrowers with good or excellent credit. However, you will generally pay more interest than a secured personal loan since the lender assumes more risk.
Debt consolidation loans
Debt consolidation loans are commonly used to pay off outstanding balances faster by saving on interest. Borrowers also benefit from streamlining the repayment process.
The idea is to get a loan with a lower interest rate than what you are currently paying on the debts you plan to consolidate. You will use the loan proceeds to eliminate these balances and make payments on a new loan product for a specified period. Ideally, you’ll save hundreds or even thousands of dollars in interest and get out of debt faster.
A debt consolidation loan can be risky if you use it to pay off credit card balances and don’t refrain from swiping cards once you clear the balances. You could end up with more debt than you started with.
Co-signed and joint loans
If you are unable to qualify for a personal loan on your own, the lender may approve you with a co-signer. This person should have a strong credit history and be willing to take responsibility for the remaining balance if you are unable to repay the loan. However, the co-signer will not have access to the loan proceeds.
Some lenders also offer joint loans, which allows both borrowers to access the funds. As with co-signed loans, both parties will be responsible for loan repayments. Your co-borrower will need good or excellent credit to boost your chances of getting loan approval.
Fixed rate loans
Fixed rate loans come with an interest rate that does not vary over the repayment term. Therefore, the borrower makes the same monthly payment for the duration of the loan.
Most personal loans fall into this category. It’s easier to build loan repayments into your spending plan because it won’t change over time.
Variable rate loans
Variable rate loans have a variable interest rate. Over time, your monthly payment could go up or down if the benchmark rate set by the banks changes.
Although it’s difficult to budget for payments on variable rate loans, the rates are sometimes lower than what you’ll get with a fixed rate loan. Thus, you should only consider this type of personal loan if you only need to borrow funds for a short period.
Personal line of credit
A personal line of credit works like a loan and you will have access to a pool of funds that you can borrow whenever you need it. Unlike personal loans, which require you to pay interest on the entire loan amount, you will only pay interest on the amount you withdraw.
This loan product is suitable for borrowers who want a safety net that can be used when needed.
Buy now, pay your loans later
Buy now, pay later Loans allow consumers to make a purchase without having to pay the full purchase price up front. Instead, the balance is divided and payable in equal, weekly or bi-weekly installments.
These loans are usually granted through mobile applications, such as Afterpay, Klarna and Affirm. You could get approved for a purchase now, repay a loan later with less than perfect credit if you demonstrate your ability to repay the loan. Most lenders will review your banking activity and may perform a soft credit check, which will not affect your credit score.
Types of personal loans to avoid
Some personal loans can mean bad news for your finances and should only be used as a last resort. Here are some options to avoid:
- Credit card with cash advance: Some credit card issuers allow cardholders to take a cash advance from their available credit at an ATM or bank. But this benefit comes at a high cost – you’ll likely have to pay cash advance fees and a higher interest rate on the amount you borrow.
- cash advance apps: These apps also give you quick access to cash, usually up to $250, until payday. Most charge a monthly fee to use this service, and you’ll need to pay back what you borrow on your next payday or within two weeks.
- Payday loans: These loans are an expensive form of debt that caters to borrowers with poor credit. Payday loans usually come with high interest rates and are payable on payday. They often create a dangerous cycle of debt if you cannot repay and extend the term of the loan.
- Pawnbrokers: If your local pawnshop offers loans, you can hand over your property in exchange for cash. You’ll likely pay exorbitant interest and the pawnbroker will keep your property if you don’t repay the loan.
How to choose the best type of personal loan for you
Ultimately, you want a loan product from a reputable lender that offers a competitive interest rate and monthly payments you can afford. It is equally important to consider the most appropriate options based on your creditworthiness, financial situation and intended use.
A personal loan could be a good choice if you need a fixed amount to make a specific purchase. But if you want the flexibility to borrow funds when you need them, a line of credit may be more ideal.
Use the Bankrate personal loan marketplace to explore your options and find a loan that meets your borrowing needs.