Understanding Different Types of Personal Loans
If you need cash to cover an emergency, make a big purchase or consolidate debts, a personal loan is one of the most straightforward financial tools you could choose. With a personal loan, a bank lends you money — ranging from a few hundred dollars to tens of thousands — typically for a fixed interest rate and fixed period of time, usually between one and five years.
This article will cut through the jargon to help you understand what kinds of personal loans are available, the advantages and disadvantages of each and alternatives.
Unsecured personal loans
Because most personal loans are unsecured loans, banks charge higher interest rates and fees than they would for, say, an auto or home loan, which is secured by your car or house, respectively. An unsecured loan is not backed by collateral.
Predictable payments. You typically get a lump sum at the beginning and then have a set payment every month for the term of the loan. This is referred to as an installment loan, a term that’s sometimes used in place of personal loan.
Good credit rewarded. Those with credit scores in the high 600s and 700s will have the easiest time getting approved, but personal loans are available for those with less-than-perfect scores.
Secured personal loans
As we mentioned earlier, a secured loan is one backed by collateral like a mortgage or car loan. And though most personal loans are unsecured loans, some banks or credit unions will offer personal loans backed by an asset like a savings account or CD. Maybe that CD has a high penalty for early withdrawal but you need the cash now. A secured loan is a way to get access to that money without paying fees or selling the asset, though you will be paying a monthly interest to the bank for the loan, and possibly fees as well.
Lower rates. Because the loan is backed by collateral, banks may offer lower rates than those for unsecured loans.
Greater risk for you. This also means the lender may be able to seize those assets should you fail to repay the loan.
There are a couple types of secured loans you probably want to avoid:
- Car title loans. Not to be confused with a loan used to buy or refinance a used or new vehicle, an auto title loan is when borrowers turn over their car title in exchange for quick cash. Though most of these loans don’t require a credit check, they also come with hefty interest rates and fees, not to mention the risk of losing your vehicle if you fail to repay.
- Payday loans. Yes, you could get cash quick with one of these small-dollar loans, but they carry an average APR of 391%. The idea is that cash-strapped borrowers receive money with the promise of repaying it on their next payday. They typically leave a postdated check for the total loan amount and fee with authorization to access the funds in their bank or prepaid account. Learn how to get out of a payday loan here.
The majority of personal loans are offered with fixed rates, so the interest rate and payment will remain steady over time.
Easier to budget – Again, predictable payments means it’s easier for you to know what you owe each month.
Higher rates – Because the lender is taking on more of the risk, rates may be higher.
Variable interest means exactly what it sounds like — your interest rate may change over the life of the loan. These are typically found with a line of credit, which some lenders offer. With a line of credit, the lender will approve you to borrow up to a certain amount.
Borrow only what you need. You can then choose what to borrow within this limit. You’ll make monthly payments, but you’ll only pay interest on the amount you borrowed.
Fluctuating rates. Interest rates are pegged to the wider market. Some lines of credit involve fees and you should check with your lender.
Secured and Unsecured Lines of Credit
Lines of credit made available by banks to clients who meet specific requirements, like having a certain amount in an account at that bank. Because you meet (high) asset requirements, no collateral may be required.
verdraft lines of credit connected to your checking account, so if you spend more than what is in your checking account in a given month you have some added flexibility (but remember you’ll pay interest on the amount you overdraw.)
One of the most common types of lines of credit is a HELOC, or home equity line of credit. Like the name implies, this a loan backed by a house. Most HELOCs have a variable interest rate that may include a lower promotional rate followed by a higher one.
Tax advantages. Not only are interest rates typically lower for a HELOC than they are for a personal loan, but the interest paid on your HELOC may also be tax-deductible if used for home improvement.
Closing costs. You will have to factor in closing costs and the possibility of higher rates when calculating the total price of this loan.
Debt consolidation loans
One reason many people take out a personal loan is to consolidate debt, including credit cards, payday and other personal loans, utility bills, and medical expenses. The idea is to roll all — or many — of those into one loan with a single payment and interest rate.
Easier to qualify. It may also be easier to qualify for a personal loan than some other methods of consolidating debt, such as credit card balance transfers.
Higher interest rates. A HELOC might have a lower interest rate, but if your credit score is between 600 and 700 and you don’t have home equity or prefer not to borrow against it, a personal loan might be a better option. Read more about debt consolidation loans here.
Debt consolidation isn’t right for everyone. If you are in debt, a debt counselor or certified financial planner can help you weigh the various options and help come up with a plan that makes sense for you.
What to know before taking out a personal loan
Before choosing a personal loan, consider what other options you have for borrowing. For homeowners, a home equity loan, HELOC or cash-out refinance may offer a way to borrow cash at a lower long-term interest rate, though there may be fees and approval may take time. If your need for cash really is short term, the amount is limited and your credit is good, a 0 percent interest credit card might turn out to be a better solution.
“You should be asking what other solutions might be available,” said Theresa Williams-Barrett, vice president of consumer loans and loan administration at Affinity Federal Credit Union in New Jersey She also said you should make sure to review all the terms of the loan in detail with the lender.
Using a personal loan to cover a major purchase may seem like an easy short-term solution, but it’s essential to look at how the monthly payments, interest rates, and fees will impact your long-term financial plan.
“I generally recommend only taking out a personal loan in cases of emergency and if there are few borrowable and/or liquid assets,” said Dennis Nolte, CFP and vice president at Seacoast Bank.
Taking out a personal loan can also impact your credit score since you are taking on new debt.
Lenders may offer personal loans as a quick way to get extra cash, but it’s still an important financial decision and one that often comes with a significant interest rate attached. They can get you through that sudden tax bill, emergency or tough month, but you’ll have to pay that money back and with interest. Make sure you explore all your options before making a decision.
“Sit down with someone and look at your whole financial history,” recommended Williams-Barrett.