5 Things to Consider Before Getting a Personal Loan

Nowadays, we seem to enter legally binding contracts most weeks. Whether we're getting a new credit card, booking a flight or rental car, signing up for a website or downloading a software application update, we just sign, or click an “Accept” button, and move on.

True, we can't hope to understand every term and condition in every one of those agreements, but it's a good idea to pause before taking on a financial commitment, and ask ourselves some questions. Here are five things to consider before signing a personal loan contract.

1. Necessity

If Americans borrowed only to buy things they really needed, the economy would grind to a halt. But, as individuals, it's worth asking ourselves very early on whether we actually need the thing we want -- and whether we want it so badly we're willing to pay the high price for it that interest and other charges almost always bring.

Suppose you want a two-year, $3,000 personal loan to replace your home theater, and are quoted 9.2 percent APR, a rate that's usually available only to those with excellent credit. You'll pay $3,295.92 over those 24 months, and, at the end, you'll still have equipment that's two years out of date. Here's a novel idea: Why not save up for it? Yes, you'll have to live with your cruddy existing system a while longer, but you'd have nearly $300 more to invest in your new one -- and the delay while you're saving would mean you could have, 24 months later, better technology.

There's nothing wrong with borrowing, providing you can afford the payments, and there are circumstances in which it's both necessary and smart. But it makes sense to ask yourself the "necessity" question, because you'll be making an informed choice, even if you decide to go ahead and indulge yourself.

2. Affordability

Readers of this website are generally pretty smart, and you're unlikely to sign up for loan if you know you'll struggle to repay it. But it's easy to be a little too optimistic in your assumptions.

When you're deciding whether you can afford the monthly payments, assume you're going to face an unexpected emergency or two: maybe your car will need repairs, or a medical bill will need paying, or your washer will break down. Are you still going to be able to comfortably make payments if something unanticipated happens?

3. Cost

Ask yourself whether the loan itself is a good deal. Obviously, shop around for a good personal loan rate, but are there things you could do to get a better one?

Get a copy of your credit report in advance, and make sure it contains no errors. Be sure you know your credit score. Is it still too low to qualify for great rates? Perhaps you should delay your loan application for a few months while you work to boost it.

4. Comprehension

Do you understand what you're getting into? Do you know how a personal loan works?  It's one thing to click the “Accept” button without reading the contract when you're updating your operating system through Microsoft or Apple. It's quite another to blindly sign a loan application. Here are six things to look out for:

  1. Are there hidden fees? You expect to pay the principal (the amount you borrowed) and interest, but some personal loans come with hidden fees, including application and monthly ones. Don't look just at the headline rate.
  2. What happens if you default? Suppose your life takes a wrong turn, and you can't make payments? How bad might the damage to your finances get?
  3. Is there a penalty if you repay early? More optimistically, your life may make a turn for the better. Is it going to cost you, if you want to prepay?
  4. Is this a standard personal loan? Personal loans aren't normally secured by your assets, and don't usually limit the purposes for which you can use the money you borrow. Make sure yours conforms to these norms.
  5. Is your interest rate fixed or variable? Some experts expect rates in general to rise soon, so variable ones may be more risky. Are there caps on how high your variable rate can rise?
  6. Are you going to have to pay loan insurance (a.k.a. payment protection insurance or credit protection insurance) premiums? If so, how much benefit are you going to get from it? And can you shop around for the best deals, or are you stuck with whatever the lender offers?

5. Preparation

Don't leave it until the last possible moment before applying for your loan. If you're constantly calling your lender for progress reports, you might come across as desperate, and set alarm bells ringing.

Given the credit crunch, it's no surprise that your lender's likely to want a range of documentation to support your application. Different companies have different requirements, but, if you're salaried, expect to have to provide some or all of:

  1. Proof of identity.
  2. Proof of residence.
  3. Bank statements for the account to which your salary is credited. It's common to require the latest three.
  4. Pay stubs. Again, the three most recent are frequently needed.
  5. Last year's tax filing. Self-employed applicants may have to provide audited financials for the last couple of years in place of proof of salary.

It's in your interests to gather together these documents before you make your application. Not only will it speed up processing, but -- who knows? -- the paperwork might even prove to your lender that you qualify for a lower rate.

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