Understanding Personal Loan Contracts
Personal loans can be useful financial tools for covering unexpected expenses and consolidating debt. While you want to pay for goods and services in full whenever possible, sometimes things come up that you need money for right now. Under the right circumstances, a personal loan provides financial flexibility to meet those needs.
Unsecured loans are especially advantageous because they’re not tied to assets such as your car or home. But secured loans must be backed by collateral. So while you may pay a lower interest rate with secured loans, you’re putting assets on the line and may lose them if you can’t repay the loan.
Before taking out a loan, whether secured or unsecured, it’s important to understand the terms of your agreement, which are outlined in the personal loan contract.
What is a personal loan contract?
You’ll sign a personal loan contract after you’ve compared different offers and decided on a lender. Some lenders may refer to the contract as a loan agreement or promissory note. The document will include important details about the loan terms, so you’ll want to review it carefully to ensure you understand your rights and repayment obligations.
Contracts for unsecured and secured loans will look largely similar, except for one important distinction. In a secured loan contract, there will be a section about the asset being used to back the agreement and how that will come into play if you’re not able to repay the loan.
What’s included in a personal loan contract?
The following are some of the key pieces of information you’ll find in a personal loan contract. Make sure to go over each of these because you want to catch any discrepancies and understand how a personal loan works before you sign.
Personally identifiable information (PII)
PII refers to information such as your name, address, birthdate and Social Security number. If these are incorrect, the loan contract may be invalidated or there may be delays in the loan disbursement.
The interest rate represents how much the lender is charging to loan you the money. How much you’ll pay in interest varies by lender and depends on factors such as your credit score and debt-to-income ratio, but it’s paid as a percentage of the loan amount.
Annual percentage rate (APR)
The APR includes all the interest and fees you will pay on the loan. It is broken down as a yearly amount. It’s important to distinguish this from the interest rate because they’re not interchangeable. The interest rate factors into the total cost of the loan, but other lender fees such as origination and closing costs are included in the APR.
The payment terms should include your monthly payment amounts and the dates on which payments are due. If you opt for an automatic withdrawal from your debit account, find out when the monthly payment will be pulled so that you can make sure to have enough money in the account to cover it.
ACH authorization terms
Automated Clearing House (ACH) authorization enables the lender to withdraw your monthly installments automatically from a designated bank or credit union account. The advantage of setting up an ACH agreement is that you don’t have to remember to mail in a check or go online to schedule payments. You don’t risk missing installments and incurring late fees (or negative marks on your credit record).
“ACH has a lot of real advantages and gets a lot of bad names because people have heard horror stories about it, but the reality is that it’s pretty effective and good,” said Joseph Toms, president of online lender FreedomPlus. “It makes it much easier on the consumer to manage. That said, you need to know what are the rights around ACH pulls.”
Toms said consumers should be clear about the terms of ACH agreements. You should know not only when payments will be withdrawn but how many times a lender can attempt to pull a payment if there are insufficient funds in your account. If you don’t have enough money in the account and a lender attempts to withdraw the money several times in a month, you may be hit with overdraft fees from your bank each time. Those costs add up, so understand exactly what types of permissions your lender is requesting.
Find out how you can revoke ACH withdrawal permissions as well, and ensure that this process is documented in your personal loan contract. You have the right to cancel these agreements, so get clear on the process for stopping those payments in case you run into a scenario in which you need to make manual payments or won’t have enough money in your account.
In an ideal world, you’ll have a great relationship with your lender, you’ll never miss a payment and the loan process will go off without a hitch. But if the ideal scenario doesn’t play out, you need to know the lender’s dispute resolution process, Toms said. Look for arbitration clauses that detail how conflicts are handled and who will mediate them, as well as which state’s laws are governing the contract.
Can I get out of my contract once I’ve signed it?
It depends on the lender. Toms said most lending companies give borrowers 24 to 48 hours, and in some cases as much as a week, to cancel their personal loan contracts. This information should be in your contract. Ask your lender about its policies if you don’t see it in the documentation.
Can I change the terms of my loan?
Typically, once you’ve signed a contract and the window for canceling a contract has closed, you’re bound by the agreement you’ve signed. But if you are unable to make your agreed-upon payments, you may be able to use a loan modification process to restructure the terms. You may need to prove that you have an economic hardship to qualify for loan modification.
At the other end of the spectrum, borrowers sometimes receive improved loan terms as a reward for on-time payments. For instance, a lender might incentivize borrowers by offering them the option to negotiate more favorable loan terms after 24 months of on-time payments. But that’s not a universal practice, Toms said, so you’ll need to ask your lender whether it offers such incentive programs.
Outside of those circumstances, you generally cannot change your loan terms, according to Toms.
What am I consenting to?
Different lenders have different terms, so you’ll need to be proactive about finding out what you’re signing on for once you’ve chosen a lending company.
Jasjeev Sawhney, head of installment lending at the online lender Avant, recommended that borrowers understand exactly what they’re agreeing to as far as communication goes. What permissions are you giving about phone calls and messaging from the lender? Know which credit reporting agency is associated with the loan and how to handle disputes with it, and ask for clarity on the information-sharing policies you’re agreeing to in the contract.
Are there prepayment penalties for paying off personal loans early?
Many lenders have stopped charging prepayment penalties, according to Sawhney. But every lender is different, and whether you’ll be charged a penalty may depend on your borrowing profile.
Toms said that for prime borrowers (those with FICO scores 670 and above) lenders generally won’t charge prepayment penalties. They may include other customer-friendly policies in the contract, such as refinancing without prepayment penalties. But if you’re a subprime borrower, you may be penalized for paying down the loan sooner. (You can check your credit score here.)
“Unfortunately, for the people who need it the most, the people who are subprime borrowers, they usually don’t extend that because they want to keep the money at the high interest rate for the borrower, which, quite frankly, is not consumer-friendly,” Toms said. “So they will build in prepayment penalties.”
But he emphasized that there’s no blanket policy that prime borrowers won’t pay prepayment penalties and subprime borrowers will, so you need to look at each lender’s terms.
What fees will I pay on a personal loan?
“The real thing you want to understand is, ‘What is the true cost of credit?’” Sawhney said. That cost may include not just the interest rate and term but other fees, such as:
- Origination fees
- Past-due fees
- Insufficient fund fees for returned checks and failed payments
- Prepayment penalties
- Ancillary or cross-sell products such as unemployment insurance
Lenders will sometimes offer discounts and promotions to make their products more enticing, but it’s important to consider the fine print around these. Sawhney gave the example of interest rate discounts for borrowers who agree to enroll in auto-pay programs. You want to know what happens if you cancel auto-pay and make manual payments, as your interest rate discounts may change if you opt out of the arrangement.
As for ancillary products, Sawhney said customers must opt into these, so make sure to read the contract carefully so that you know exactly what services you’re purchasing and can reject any unwanted offers before you accept the loan.
Toms said to pay attention to origination fees as well. Some lenders will charge an origination fee up to 8%. Others will advertise loans without origination fees, which sounds like a deal. But Toms said lenders usually make up those costs via annual account fees, higher monthly servicing fees, higher interest rates or other fees. Look at the entire cost picture rather than focusing on one or two promotional aspects.
Who is liable for the loan?
If you have a co-borrower or cosigner on the loan, they must understand that they are responsible for the loan being repaid. Cosigners use their good credit standing to vouch for you. If you don’t repay the loan, it’s on them to ensure that payments are made on time. Otherwise, their credit score will suffer.
Co-borrowers are equally responsible for the loan, so make sure that everyone involved is clear on their obligations and how much they’ll need to contribute to the payment each month.
What do I do if I can’t repay my loan?
Your contract should include detailed information about how the lender will respond if you miss or stop making payments. But talk to your lender as soon as possible when you realize you’re going to miss a payment or can no longer afford to repay the loan, Toms said. He said most will work with you to create a feasible repayment strategy or implement a loan modification program.
“When people run into trouble, they’re reluctant to talk to their lender about it because it’s emotionally stressful and it’s just hard to talk about,” Toms said. “That’s the wrong course of action. If you’re really in a position where you’re unable to pay, the best thing to do is gather the documentation around why that’s the case … and reach out to the lender as quickly as possible.”
When lenders see documented proof of financial hardship, they’re often willing to work with you to avoid a charge-off, Toms said. If that happens, your FICO score will take a significant hit and you may have trouble borrowing money in the future, so you want to avoid defaults and charge-offs if at all possible.
There’s always a risk when taking on debt, even if you’re confident you’ll be able to repay your loan. If you lose your job, become sick or have another type of emergency, you may fall behind on your payments and risk hurting your credit score or, in the case of secured loans, losing important assets.
While personal loans can help you cover expenses when you don’t have enough savings to pay for them outright, it’s best to plan so you can borrow as little as possible.
“I think people should avoid taking out personal loans at all costs,” said David Claffey, head of communications at Earnin.
He recommended that consumers create a budget to understand their circumstances, no matter what those may be. “Even if you’re in the negative, understanding the ins and outs of your financial situation is incredibly important,” Claffey said.
If you do need to take out a personal loan, having a budget will help you understand how much debt you can afford to take on based on what you’re bringing in and spending each month. Claffey also recommended creating an emergency savings account with whatever you can afford to set aside from each paycheck. Then, if you do need to take out a personal loan, you can borrow a lower amount that’s easier to repay.
The bottom line
Personal loans are sometimes necessary components of your financial strategy. To maximize their usefulness and avoid going deep into debt, study the terms of your personal loan contract and make sure you’re receiving a good deal that you’ll be able to repay on time.