Personal loan

What you need to know before taking out a personal loan

There are a lot of things to know when looking for a personal loan. For example, how is a personal loan different from more familiar types like auto loans and mortgages? What can you use personal loans for? Are there alternatives to the personal loan?

To get the answers to these and other questions, Investopedia spoke with Linda M. Hooks, head of the economics department at the University of Washington and Lee in Lexington, Virginia. In addition to leading the largest department in Washington and Lee, Dr. Hooks has conducted and published research in various economic fields. Our edited conversation follows.

How personal loans differ from other types of loans

Investopedia: To begin with, what is a personal loan and how is it different from other types of loans?

Hooks: A personal loan is a loan with a fixed maturity for an individual consumer. An individual borrows money now and pays it back over a period of time by paying the same amount monthly. In this way, it is akin to a car loan or mortgage payment. It is different from these types of loans because it may not require collateral or any valuable item like a car or a house that you agree to lose if you cannot pay it back.

Investopedia: What can personal loan funds be used for?

Hooks: Personal loans are versatile. They can be used for purchases too large to be bought with cash, such as a new appliance or an air conditioner. They can sometimes be used to consolidate other debts. They can be used for one-time expenses like medical bills, education costs, or maybe a special trip.

How to qualify for a personal loan

Investopedia: What qualifications do you need to have to apply for a personal loan?

Hooks: As with most loans, the main qualification is a good credit history. Sometimes it may be possible to use collateral for a personal loan, which can help you qualify for a personal loan or for a better rate on the loan. Ask your bank what might be accepted as collateral, such as savings accounts or an insurance policy.

Investopedia: Where can people find out about their credit score and does it cost money?

Hooks: Usually, you can only get a credit score by paying a fee. However, you can get a free credit report from the AnnualCreditReport.com website. You can find additional information about this service, including a phone number and mailing address if you prefer to order a report this way, on the Federal Trade Commission website titled Free Credit Reports. The information in your credit report forms the basis of the credit score, so you may not need to see the actual credit score, as long as your credit report appears correct.

Factors That Determine How Much You Can Borrow

Investopedia: How Do Lenders Determine How Much People Can Borrow?

Hooks: To determine how much a person could borrow, lenders use the credit rating as well as other factors such as a possible guarantee or an existing financial relationship with you.

Investopedia: What are the ways to improve your chances if you are not approved?

Hooks: If your request is denied, you have a right under federal law to know why it was denied. It can help you decide what to do next. Often times the denial is due to a low credit score and you can work to improve the score. Some steps to improving your credit score include paying bills on time and paying the required amount, which is at least the minimum payment required on a credit card. You should pay more than that, if possible. Do not charge the maximum allowed by your credit cards, that is, keep the balance well below the maximum.

Prepayment, co-signers and other loan options

Investopedia: Can we repay a personal loan in advance or does it depend on the conditions of the loan?

Hooks: Prepayment of the loan may be possible, but it depends on your specific loan. Ask before signing the loan documents if there would be a penalty associated with prepayment.

Investopedia: What is a co-signer and when can a borrower need one?

Hooks: A co-signer is an additional person who agrees to repay the loan if you cannot. Having a co-signer can help someone with a limited credit history get a loan. However, the co-signer should know that they are responsible for the loan in the same way they would be if it were their own loan. It can also affect the credit history and score of the co-signer.

Investopedia: What are the alternatives to the personal loan?

Hooks: Alternatives to a personal loan can include a home equity loan or a credit card. Another alternative, if it is a planned expense, is to save for the purchase and only buy it after saving the funds for the item.

Protections offered to borrowers

Investopedia: Where do you go to complain if you think your lender is doing something illegal or wrong?

Hooks: The Consumer Financial Protection Bureau (CFPB) was established under the Dodd-Frank Act of 2010 to provide consumers with resources and a means to file complaints about financial services. The website is www.consumerfinance.gov/.

Investopedia: What if you have financial problems and can’t repay your loan?

Hooks: If you are having financial problems and think you would have difficulty making a payment, contact your lender as soon as possible. There may be federal government programs that can help you as well, and you can find information about this on the CFPB website above.

Final thoughts

Investopedia: What final advice do you have for those considering a personal loan?

Hooks: Think carefully about the option of obtaining a personal loan. For example, in some circumstances it may be a good idea to forgo a personal loan in order to qualify for a mortgage instead.

Where can I get my credit score?

According to the Bureau of Consumer Financial Protection, there are four ways to get your credit score:

  • Check credit card or loan statements. Many large credit card companies show your credit score on your monthly statement.
  • Talk to a nonprofit credit counselor. Nonprofit and HUD approved counselors can provide credit scores and review them with you.
  • Use a credit score service. Some services offer a “free credit score” but require you to purchase a subscription. Others, funded by advertisers, do not charge a fee.
  • Buy your sheet music. Credit reporting companies will sell your score to you. You can also buy your sheet music on myfico.com.

Is there a penalty for early repayment of my personal loan?

It depends on the terms of your loan. It’s always wise to ask about penalties, including prepayment penalties, before signing up for a loan.

Which is better: a private student loan or a personal loan?

A private student loan has lower interest rates, offers greater repayment flexibility, and generally allows you to amortize interest payments on your taxes. If you need the cash to pay for your college expenses, a private student loan is probably the best. If you have other expenses unrelated to school, a personal loan may be preferable.


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