How Do Personal Loans Work?
If you are short on funds, a personal loan is one option available to you. However, this may not always be the best choice, so be sure to fully understand how personal loans work before taking one out.
Personal loan characteristics
Personal loans are unsecured. There is no property, such as a home, offered as collateral. This is a key difference between personal loans and other types of loans.
- Rates are higher. Because they are unsecured, interest rates for personal loans are higher than secured loans (such as a mortgage or home equity loan). Still, they are lower than credit card rates — after the credit card’s initial teaser rate, that is.
- They have a fixed term. A personal loan can be due at the end of a set term, in which case the interest rate is fixed.
- Sometimes, a revolving line of credit is offered. Occasionally, a personal loan can also work as a revolving line of credit, like a credit card. In such a case, the interest rate is variable.
- There are no tax benefits. The interest on a personal loan is not tax deductible, unlike the interest on a mortgage or home equity loan.
If you don’t own a home, or you don’t have much equity in your home, a personal loan may be your best choice if you are in need of money. If you get a personal loan with a fixed rate and term, it forces you to be disciplined and pay the loan off within the specified time frame unlike a credit card, which tempts you to continue spending. Also, the interest rate on a personal loan is usually lower than that of a credit card, although the credit card’s initial teaser rate may be lower.
A personal loan has some disadvantages to consider. For example, the interest payments are not tax deductible, while the interest on a loan secured with property usually is. Also, rates can easily be over 10 percent on a personal loan. Mortgages and home equity loans are usually closer to 6 percent. Therefore, you end up paying far more on a personal loan than you would on a home equity loan for the same amount.
Still, in some situations, a personal loan is the best option. If that is the case for you, be sure to consider your options carefully. Compare products from several different lenders. You can do compare offers online at sites such as www.LendingTree.com. Different lenders have different fees for personal loans, so it is important to shop around. Use a personal loan wisely and only get one if you really need it.