If you’re looking to use a personal loan to overcome a financial hump or consolidate debt, you’re not alone. According to a study by Bankrate, the average consumer had around $16,458 in personal loan debt in 2020. Before proceeding to borrow the funds you need, you should compare the types of credit available.
What is a personal loan?
A personal loan is a debt product available through a bank, credit union, or online lender. It is commonly used to cover a financial emergency, do home improvement, or consolidate debt. Most personal loans are paid out as a lump sum and are payable in installments over a set period of time, usually between one and seven years.
Count on interest between 4 and 36 percent, depending on your credit rating and the loan product you have chosen.
Types of Personal Loans
There is a selection of personal loan options to choose from and you are offered a variable or fixed rate.
Secured Personal Loans
Secured personal loans require you to deposit an asset that serves as collateral. For example, you could take out a loan for your vehicle called a title loan.
While this might be an ideal option if you have a lower credit rating and an asset to post as collateral, there is a downside. If you default on the loan payments, the lender could seize and sell your assets to collect the debt owed.
Unsecured Personal Loans
These loan products do not require collateral to be approved. It also gives you quick access to funds without jeopardizing your wealth.
Unsecured personal loans are best for borrowers with good or excellent credit. However, you typically pay more interest than with a secured personal loan because the lender is taking on a higher risk.
Debt Consolidation Loan
Debt consolidation loans are often used to pay off outstanding debt faster by saving on interest. Borrowers also benefit from the streamlining of the repayment process.
The idea is to secure a loan at a lower interest rate than you are currently paying on the debt you wish to consolidate. They use the loan proceeds to eliminate these balances and make payments on a new loan product for a set period of time. 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’re using it to pay off credit card balances and you don’t refrain from swiping the cards once you’ve canceled the balances. You could end up in more debt than you started with.
Co-signed and joint loans
If you cannot 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 balance if you default on loan payments. However, the co-signer does not have access to the loan proceeds.
Some lenders also offer joint loans that allow both borrowers to access the funds. As with co-signed loans, both parties are liable for the loan payments. Your fellow borrower needs good or excellent credit to increase your chances of getting a loan approval.
Fixed rate loan
Fixed rate loans have an interest rate that does not change over the term. Consequently, the borrower makes the same monthly payment for the duration of the loan term.
Most personal loans fall into this category. Incorporating the loan payments into your spending plan is easier because they don’t change over time.
Floating Rate Loans
Adjustable rate loans have a fluctuating interest rate. Over time, your monthly payment may go up or down as the reference interest rate set by banks changes.
While it is difficult to budget for payments on an adjustable rate loan, the interest rates are sometimes lower than on a fixed rate loan. So you should only consider this type of personal loan if you only need to borrow money for a short period of time.
Personal Line of Credit
A personal line of credit works like a loan, giving you access to a pool of funds that you can borrow money from whenever you need money. Unlike personal loans, where you have to pay interest on the entire loan amount, you only pay interest on the amount you draw down.
This loan product is suitable for borrowers who want a safety net that can be tapped when needed.
Buy now, pay credit later
Buy now, pay later Credit allows consumers to make a purchase without paying the full purchase price up front. Instead, the balance is split and paid in equal weekly or bi-weekly installments.
These loans are usually granted through mobile apps like Afterpay, Klarna and Affirm. You could be approved for a purchase now and later pay off a loan with less than perfect credit if you can show that you can repay the loan. Most lenders will screen your banking activity and may conduct a soft credit check that will not affect your credit score.
Types of personal loans to avoid
Some personal loans could mean bad news for your finances and should only be used as a last resort. Here are some options to avoid:
- Credit card with prepayment: Some credit card issuers allow cardholders to take a cash advance from their available balance at an ATM or bank. But this benefit comes at a high cost — you’ll likely be hit with a cash advance fee and a higher interest rate on the amount borrowed.
- cash advance apps: These apps also give you access to quick cash until payday, usually up to $250. Most charge a monthly fee to use this service, and you must pay back what you borrowed on your next payday or within two weeks.
- payday loan: These loans are a costly form of debt aimed at borrowers with poor credit ratings. Payday loans usually carry high interest rates and are payable on payday. You often create a dangerous cycle of debt if you cannot repay and extend the loan term.
- pawn shop: If your local pawn shop offers credit, you can sell your assets for cash. You’re likely to pay an exorbitant amount of interest, and the pawn shop will keep your property if you default on 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 that you can afford. It is equally important to consider the options that best suit your credit rating, financial situation and intended use.
A personal loan could be a good choice if you need a specific amount for a specific purchase. However, if you want the flexibility to borrow funds when you need them, a line of credit may be more ideal.
Use Bankrate’s personal loan marketplace to explore your options and find a loan that meets your credit needs.