Your Ultimate Guide to Personal Loan [Covered Everything]

A personal loan is a monetary support from the lender in return for interest payment that requires to pay the entire debt within a stipulated time farme.

But navigating the world of personal loans can feel like traveling a complex puzzle. You need to know how to prepare for it, what documents you need, how to qualify, the causes of rejection, the choice of different loan options, and a lot more.

We aim to break it down into simpler terms, using real-life examples and a touch of personal experience to guide you through.

So, what is a personal loan?

In simple terms, a personal loan is the sum of money that you borrow from any bank, credit union, other financial institutions, or online lenders.

Typically, such loans have a tenure of two to seven years and a fixed monthly payment (EMI). Interest is normally fixed but there can be a clause in your loan terms that the lender has the right to revise the interest considering economic circumstances.

Remember, the interest of any personal loan can be high because the loan itself is ‘Unsecured’ in nature.

So, what does the term ‘unsecured’ mean?

An unsecured loan represents that the borrowed money is not backed by any security. For example, if you take a car loan, the car is mortgaged against the facility you take from the bank.

In case of default, the lender has the right to seize the car and encash what you owe to the bank.

In a personal loan, the lender provides you the money in good faith that you will pay it back slowly. Normally, payslips or your bank statements are needed to check the regularity of your earnings.

Who gives unsecured personal loans?

You may get unsecured personal loans from any bank, credit union, or from online lenders who are registered as a financial institute.

Banks are often the first place many people think of when considering a personal loan. The main advantage of going through a bank, especially one where you already have accounts, is the potential for lower interest rates and fees for existing customers.

It’s easy as the bank can see your earnings and frequency from the statement or payslips. Usually, clients with a particularly long banking history receive such loans quickly due to less due diligence required.

Banks can also offer higher amounts of loans but, the downside is that banks usually have a stricter credit score and income requirements, making it harder for those with less-than-perfect credit to get approved. Additionally, the loan application process can be more time-consuming and involve more paperwork.

Credit unions and online lenders can be your alternative options with their own set of benefits and drawbacks.

Credit unions are member-owned and often provide more personalized service with potentially lower rates than banks, even for those with average credit scores. Credit unions are a good choice for borrowers looking for a more community-based lending experience. For instance, your nearest credit union will accept your loan application if your living and business area is near its territory.

On the other hand, online lenders are known for their convenience and speed, often making instant decisions on loan applications and funding loans quickly. They cater to a wide range of credit profiles, including those with poor credit.

You may not receive large amounts of loans from the online lenders unless your credit score is good. However, this accessibility can come at a cost, with some online lenders charging higher interest rates and fees compared to banks and credit unions.

Factors Affecting Your Chance of Getting a Loan

In summary, your credit score, income, debt-to-income (DTI) ratio, and employment history are the primary factors when considering an unsecured personal loan.

A high credit score signals to lenders that you’re a low-risk borrower, which can not only increase your chances of approval but also secure you more favorable loan terms, such as lower interest rates.

Stable income, regular earning frequency, and employment history strengthen a loan application as they represent that you earn regularly and will pay the loan back as per the payment schedule.

However, there are other factors to consider.

Having an existing relationship with a lender can work in your favor by reducing the due diligence time. We observed that customers with a history of positive dealings with a bank or credit union might find more flexibility in loan approval processes.

Moreover, the purpose of the loan can also impact the decision; loans for debt consolidation or home improvement might be viewed more favorably than loans for more discretionary expenses like vacations. This is only because the lender needs clarity or signals about your trustworthiness in paying back the borrowed amount.

Economic conditions and market trends can affect lending practices, with lenders possibly tightening or loosening their criteria based on the overall economic environment.

For example, if your country’s economy is going through high inflation, the lender may not accept your loan application. The reason can be the low credibility of your future earnings or the lender itself looking for a better client due to its fund shortage of regularity compliance.

Sometimes, the government takes institutional loans either to balance the economic stability or to finance mega projects. In such circumstances, loan applications with poor credit or risky DTI ratio may not get approval like normal times.

How many types of personal loans are there?

Personal loans come in two main types: secured and unsecured. Secured loans require you to provide collateral, such as your home or car, which the lender can seize if you fail to repay the loan.

For example, if you take out a secured loan for home improvements, you might use your home equity as collateral. This type often has lower interest rates due to the decreased risk for the lender.

On the other hand, unsecured loans don’t require any collateral, making them a riskier proposition for lenders and often resulting in higher interest rates for borrowers.

An example of an unsecured loan would be borrowing money to consolidate credit card debt without having to offer up any property or assets as security.

The choice between the two depends on the borrower’s financial situation, their access to collateral, and their willingness to risk that collateral in case of non-repayment.

You may also take unsecured loans after showing your income proof and buy a car with the money. However, unsecured loans are always costly and may consider such situations only when you are sure about your future earning stability.

When would you consider a secured loan?

A secured loan is a type of loan backed by collateral (security), meaning the borrower pledges an asset they own, such as a car or a house, to secure the loan.

For example, if you’re looking to undertake a significant home improvement project in Miami and decide to take out a secured loan, you might use your car as collateral. This provides a safety net for the lender since they have the right to seize the asset if you fail to repay the loan.

The advantage of secured loans is they typically come with lower interest rates compared to unsecured loans due to the lowered risk for the lender.

The pros of secured loans include lower interest rates and potentially higher borrowing limits, making them suitable for larger expenses or projects.

Additionally, they can be easier to qualify for if you have less-than-perfect credit because the lender has the collateral to fall back on.

However, the cons are significant; the harsh truth is the risk of losing your collateral. Here’s a guide that tells what cannot be your collateral for the secured loans.

Failing to repay the loan means you could lose your car, house, or whatever asset you pledged, impacting not just your financial stability but potentially your lifestyle and mobility.

In the USA, the specifics of secured loans, including interest rates and terms, can vary widely depending on the lender and the type of collateral. According to Investopedia, the interest rate rises for used vehicles and people having a credit score of below 661.

For instance, the interest rate for a secured auto loan can be under 10% for borrowers with good credit, whereas secured personal loans might have slightly higher rates, depending on the asset and the borrower’s credit profile.

Learn how lenders assess borrower’s loan profile.

It’s crucial to shop around and compare offers from different lenders to ensure you get the best terms possible. Furthermore, understanding the value of your collateral and the loan terms is essential.

In some cases, the asset might depreciate over the loan’s life (as with cars), affecting the loan’s dynamics and your financial strategy. Borrowers should weigh these factors carefully against their need for funds and their ability to repay the loan.

What are the considerations of unsecured loans?

An unsecured loan is a type of financing where the borrower does not need to offer any collateral to secure the loan.

This means that if you borrow money through an unsecured loan, you aren’t required to pledge assets like your home or car as a guarantee of repayment.

For instance, if you’re faced with sudden medical bills and need to cover the costs quickly, an unsecured personal loan can provide the necessary funds without putting your assets at risk.

This characteristic makes unsecured loans a popular choice for financing short-term needs or consolidating debt.

The biggest advantage of the unsecured loans is no need of a security for the borrowed amount.

On the downside, unsecured loans usually come with higher interest rates, reflecting the higher risk the lender takes by not requiring collateral.

We also observed that the terms of an unsecured loan are less flexible than those a secured loan and the interest rate is higher.

What is open and close end loan?

A close-end loan has a predetermined end date and an open-end loan is revolving in nature.

In close-end loan, the borrower receives the full money upfront and pays in installments that eventually end after a particular period.

However, an open-end loan offers the borrower a credit limit for a given time and he withdraws whatever money is required.

In a nutshell, the credit limit becomes available to use after the payment in open-end loan and there is no such revolving limit in the close-end loans.

In summary, open-end loans are more flexible than the closed-end loans.

How do interest rates affect personal loans?

For personal loans, be it secured or unsecured, the interest rate can either be fixed or flexible.

Fixed rates stay the same throughout the loan term, offering predictability. Variable rates can fluctuate, potentially lowering your payments but also introducing uncertainty.

Imagine you’re in the market for a $20,000 loan to buy a used car. If you go for a fixed-rate loan at 5% interest over a 5-year period, your monthly payments are set in stone from the start.

This means you’ll be paying the same amount each month, let’s say around $377, without any surprises.

This predictability is great for budgeting because you know exactly how much you need to set aside for your car payment each month, regardless of changes in the interest rate market. It’s like locking in your monthly payment against future rate hikes, offering a sense of financial security over the loan term.

Now, consider a variable-rate loan where you start with a 4% interest rate, which gives you a lower initial monthly payment, perhaps around $368.

At first glance, this looks like a sweet deal because you’re saving money every month compared to the fixed-rate option. However, here’s the catch: if the interest rates in the market increase due to economic changes, your loan’s interest rate could jump to 6% or higher.

This would increase your monthly payment, potentially making the loan more expensive over time. For instance, your payment could rise to $387 or more, depending on the rate adjustments.

While you might save money initially, you’re also taking a gamble on future interest rate changes, which could end up costing you more in the long run if rates rise.

This option requires a bit more financial flexibility and risk tolerance, as your monthly budget could need to adjust to accommodate the changing payments.

Illustration of simple and compound interest rate

A simple interest rate means that there will be a flat interest rate over your principal amount and then the whole amount will be divided by the total number of years or months.

Compound interest represents that the interest rate will be applied in a compounding manner (multiplying manner).

Banks usually prefer compound interest rates because they consider the impact of the time value of money.

In a nutshell, Simple Interest might be better if you prefer straightforward calculations and slightly lower total repayment. Compound Interest can be beneficial if the interest rate is lower or if the compounding period is not frequent, but generally, it results in higher total repayment.

Here’s an example of both interest types:

For the $10,000 loan amount with 5% interest and 3 years of tenure, the interest amount becomes 10,000×0.05×3=1,500. So, the total loan payment (principal + interest) would be 10,000+1,500=11,500 (assuming that there are no processing fees and other charges for both cases.)

In a compounding manner and for the same loan amount, interest, and tenure, the total payback amount becomes 10,000 x (1.05)3 or, 11,576.25.

So, you are paying 76.25 extra for the compound interest mechanism. This is the reason we recommend compound interest if that is lower than the sample rate.

How does APR affect personal loans?

The Annual Percentage Rate (APR) encompasses the interest rate plus any fees. It’s a more accurate reflection of the loan’s cost. A lower APR means a lower cost to borrow.

The Annual Percentage Rate (APR) is like the all-in cost of your loan, rolled into a single percentage. Unlike the basic interest rate, which only shows the cost of borrowing the principal amount, the APR includes all the fees and costs associated with the loan over its lifetime.

This might include origination fees, processing fees, or any other charges the lender might apply.

For instance, if you’re taking out a $15,000 loan with a 5% interest rate and a $300 origination fee, the APR will be higher than 5% because it spreads this fee out over the life of the loan, showing the true cost of borrowing.

To put this into perspective, consider two offers for a $20,000 auto loan over five years. Lender A offers a 4% interest rate with a $500 origination fee, while Lender B offers a 4.5% interest rate with no fees.

At first glance, Lender A seems to have the better deal. However, when you calculate the APR, Lender A might have an APR of around 4.5% to account for the origination fee, while Lender B’s APR remains at 4.5%. This makes Lender B’s offer equally competitive, despite the higher interest rate, because there are no additional fees increasing the overall cost of the loan.

The APR effectively levels the playing field, allowing you to compare different loans on an apples-to-apples basis, making it clear that a lower APR signifies a lower cost to borrow, and is thus more desirable for a borrower looking for the most cost-effective loan.

How does credit score affect loan application?

We all know that the credit score tells about your payment behavior. A higher credit score means that you can offer big confidence to the lender about paying back the borrowed money in the future.

Consider taking a car loan from the USA.

If your credit score is somewhere between 661 to 780, your interest rate for a new car is likely to be 7.01% as per Investopedia.

However, if your credit score stays at a range of 601 to 660, the interest rate for the same car would become 9.60%.

The poorer the credit score you have, the larger the interest will be.

So, someone having a credit score of 595 would even see an interest rate of 12.82% for the same car.

Here’s how you can improve your credit score over time.

So, how would you prepare yourself for a loan?

Since everyone’s purpose and credit score are different, you need to understand the terminology of loans and their subsequent impacts.

First, you need to showcase your confidence about the future payback. In that case, your earnings and their regularity would help you a lot. Learn, how banks consider overdue installments for your future loan applications.

Secondly, you need to build credit scores slowly so that your profile seizes the deal at the first stage of your loan application.

Further, learn how to compare separate loan options, if you can separate the principal amount, know your APR, and compare the interest rates, the entire process will become easy.

Here’s a step-by-step process for a personal loan application:

Assess Your Needs and Creditworthiness

• Determine how much money you need.
• Check your credit score and credit report to understand your creditworthiness.

Research Lenders

• Compare different lenders, including banks, credit unions, and online lenders.
• Look at interest rates, loan terms, fees, and customer reviews.

Prequalify for Loans

• Use prequalification tools to see if you might qualify for a loan and what terms you might receive without affecting your credit score.

Gather Required Documentation

• Prepare necessary documents such as identification, proof of income, employment verification, bank statements, and any other documents the lender requires.

Submit an Application

• Fill out the loan application form provided by your chosen lender.
• Submit the required documentation along with the application.

Await Approval

• The lender will review your application and documents.
• They may perform a hard credit check, which can temporarily lower your credit score.

Receive Loan Offers

• If approved, review the loan offers you receive.
• Pay attention to the interest rate, monthly payment, loan term, and any fees.

Accept a Loan Offer

• Choose the loan offer that best suits your needs and financial situation.
• Sign the loan agreement.

Receive the Funds

• The lender will disburse the loan amount to your bank account.
• This process can take anywhere from a few hours to several days.

How to ace your loan application?

By executing the following strategies, you can make your debt processing faster than the others:

• Review your credit scores in advance so that you can have hints about your credit limitation and stay ahead with the expected APR.
• Depending on the type of your debt, you need select the lender strategically. Select lenders known for fast processing times. Keep in mind that online lenders often provide quicker approvals compared to traditional banks.
• There are online prequalification tools that are found on lenders’ websites. You can complete the prequalification stage so that the lender can make a preliminary review of your application even before you approach them.
• Make sure you gather all the required documents which are needed for loan applications. Documents such as income proof, job experience certificate, bank statements, and asset valuation can make your application faster.
• Always provide accurate information so that the lender does not need to revert your file for further verification and amendments.
• Usually, a small amount of loan gets approval fast, so consider applying for a small amount if you need fast approval.

How can you reduce the net cost of your loan?

The ultimate way of minimizing the net cost of debt is having a good credit score and paying the loan payments timely.

Here’s a list that will help you minimize the cost of your loan:

• Improve your credit score by paying bills on time and utilizing the credit limit carefully.
• Compare multiple lenders and choose the one with lower APR.
• Choose a shorter loan tenure which will have lower interest due to compound interest.
• Always negotiate with your neder and try to reduce fees or interest rates.
• Sometimes make extra payments that will save you from any future overdue payments,
• Consider a secured loan, which is always cheaper than unsecured loans.
• Set auto pay or, standing order so that the loan payments get debited automatically from your account.
• If you have multiple high-interest debts, consolidating them into a single loan with a lower interest rate can save you money.

How will you manage your debt portfolio?

Managing a debt portfolio is crucial if the borrower holds different types of loans from multiple lenders. A mismanagement can cause excess cost that also negatively affects the credit score of the borrower.

You need to identify which debt management strategy applies to you and how can you execute it so that the debt portfolio gets healthy and does not harm your economic stability.

Managing debts would require a budget and cost-cutting. The intention is to make extra savings so that a borrower can pay off loans at a higher cost.

We have a different article that guides the borrower on how to manage loans.

How can you delay loan payments?

Delaying loan payment is recommended but, there are mechanisms such as using the grace period, restructuring, and rescheduling that can be effective if you are facing financial difficulties.

Your loan offer letter or the sanction letter would mention the grace period (usually 10 to 15 days). The grace period represents that even if your late payment is within the allowed grace period, there would be no penal interest (extra interest).

Loan payment can also be delayed with rescheduling and restructuring.

Rescheduling a loan represents that you request the bank to give you a revised date (usually an extension) to make your payments.

Alternatively, loan restructuring means that the borrower requests the lender to convert his/her remaining loan payments into a new loan for some additional months or years. In this way, restructuring makes the EMI smaller which becomes effective for the borrower to pay the loan without harming his/her credit score.

How can you avoid loan rejection?

A personal loan can be denied due to a bad credit score, high DTI, inaccuracy on the given information, not fulfilling the lender’s requirement, and not justifying the borrowing limit.

Whatever the reasons are, your first job is to address the main reasons for your loan rejection and work on the factors that affected the lender’s decision.

We saw, in most of the cases. a reapplication with an improved credit works fine. However, an applicant can bring a co-signer or choose a secured loan by pledging an asset as a security to maximize the chance of acceptance.

Can you refinance a personal loan?

Yes, personal loans can be refinanced. Refinancing represents taking a new loan to pay off the old liabilities.

Refinance is usually effective if your previous APR is larger than the new APR. Alternatively, refinance can be useful (similar to restructuring) to reduce the monthly payment amounts. Let’s say, you have paid 50% of the original debt and you have taken another loan to pay off your remaining 50%.

Practically, the loan would allow you to avail lengthier tenure than the earlier remaining debt.

When can you consolidate a personal loan?

Consolidation or, merging loans is possible if you have multiple debts. Usually, loans with higher interest rates, and if you are facing financial difficulties in making timely payments.

debt consolidation is if your new terms are better and cost-effective than the earlier loans.

To consolidate, list all your debts, including outstanding balances, interest rates, and monthly payments. Check your credit score, calculate your potential savings, and apply for the consolidation if it is financially viable.

Once approved, you can pay off the earlier debts.

How does a joint loan affect your credit score?

Personal loans can be taken jointly with your partner. Sometimes joint loans are quickly approved because the lender puts two people obliged for the borrowed amount.

However, a joint loan represents a shared responsibility meaning that each needs to maintain the loan account jointly. Alternatively, it also represents that the credit is shared between both.

Due to such a shared nature, any missed payment of the joint debt immediately affects both people’s credit health.

Who can be the loan guarantor? what are the guarantor’s responsibilities?

A loan guarantor or, a co-signer is someone who agrees to pay the debt in case of default.

A guarantor (co-signer of the loan) can be related to you and the person needs to agree to settle off your debt in case of your absence or inability.

However, lenders do not take possession of the guarantor’s account immediately after a few missed payments. The borrowers wait and chase up the lender first, and then file a petition to court in need.

Most importantly, a co-signer’s credit health is also affected when the lender misses out on any loan payment.

What is loan top-up?

Usually, banks allow a loan top-up by giving you a balance amount that you have already paid. For example, let’s imagine that you have a loan of $5000 and you have paid $2000 till today. You can apply for a loan top-up which will allow you to take paid $2000 again and start the new obligation of $5000 and revised terms.

For the topped-up loan, the interest rate is revised per the borrower’s credit score.

Can an individual avail revolving loan?

A revolving loan or open-end credit facility allows someone (can be an individual or a business) to avail a particular credit limit for a given time. Such a debt facility allows the borrower to withdraw the money he needs (within the allowed limit) and pay it back.

Line of credit or, credit card is an example of a revolving debt facility that does not give you money upfront but allows the borrower a credit time on a revolving basis.

Revolving loans have interest and it needs renewal too.

How would you make a personal financial goal?

Taking loans and bearing their costs for a time frame would require a strict budget, otherwise, your credit score and future financing opportunities will get shorter. We suggest you to work on personal financial targets by assessing your income and setting, categorizing & prioritizing your budget so that your future financial planning becomes as planned.

Here’s how you can work on your financial targets.

Below is a personal loan calculator that helps you to identify the monthly payment amount.

Conclusion

Personal loans are often quick if you have a very good credit score and income proof. Unsecured loans are often costly and require higher credit requirements. You need to learn about your APR, and loan terms, and plan your future payment schedule.

Remember, an overdue installment will always harm your future credibility to the lenders.