5 Things You Need to Know Before Taking Out a Personal Loan

5 Things You Need to Know Before Taking Out a Personal Loan
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<p>Having a payment plan in place can help make managing your budget easier. </p>

Having a payment plan in place can help make managing your budget easier.

By Catherine New, Senior Editor at Earnest

Personal loans can give you the capital you need for a number of life circumstances -- from credit card consolidation to a home remodel.

They can also be a way to build credit and help you afford a purchase that you wouldn't have enough money for otherwise.

But a personal loan will also add to your debt load, so it's important to do your research and shop around before choosing a loan provider.

Before going ahead with your application, read through these loan basics.

1. Interest rates can be lower than those for a credit card.

A personal loan can be an option for a purchase that isn't something you're willing to go without but would accrue serious interest if you put it on a credit card.

Average credit card interest rates, even for those with excellent credit, are typically more than 10 percent, and rates for those with weaker credit are often closer to 20 percent.

Personal loans, on the other hand, may offer rates of less than 10 percent if you have excellent credit.

2. Personal loans are not typically collateralized.

You might be wondering why it's possible to get a loan for a new car or home at interest rates anywhere from zero to around 4 percent, while credit card and personal loan rates are typically much higher.

One difference is that car and home loans are typically "collateralized" -- that is, there's a physical object the lender could take away from you if you can't make payments and default on your loan.

If you stop making your car payment, for example, your car could be repossessed. When we're talking unsecured personal loans, on the other hand, there's no physical "collateral" to guarantee your loan. Lenders are taking on a bigger risk by offering you money, so they generally charge you more interest to protect against that risk.

3. There may be fees associated with the loan.

Interest rates and APR (annual percentage rate) are not always the same thing -- the interest rate is the actual cost to borrow the loan not including fees, while the APR is the cost to borrow the loan plus additional fees charged by the lender.

For example, a lender may say your interest rate is 8 percent -- but then charge a 3 percent origination fee for a total of 11 percent. This is why it's important to research what your personal loan offer really means.

The Truth in Lending Act (TILA) requires lenders to disclose the APR, which is the number you should use to compare loans. Make sure you check out your APR, not just the interest rate, before signing on with any lender.

4. Your personal loan will likely show up on your credit report and could affect your credit score.

As with credit cards or student loans, personal loans are typically reported by your lender to the credit bureaus and will likely show on your credit report.

If you make on-time payments on your loan, this could contribute positively to your credit health because it adds a line of credit to your report and positive repayment history.

However, if you miss a payment or default on your loan, this may negatively affect your score.

5. It's important to have a payment plan.

Make sure you have a payback plan in place before taking out your personal loan. For example, say you're taking out a loan for a home improvement with a $500 monthly payment.

Before applying and signing for the loan, review your budget to figure out where that extra $500 per month will come from.

"You must have a great handle on your budget and make sure there is ample income to satisfy the liability, even under a tight cash-flow scenario," says Justin Goodbread, a Certified Financial Planner™.

He recommends having an emergency fund in place before you take out a loan on top of having the resources to make repayments.

Bottom Line

A personal loan can be a good alternative way to get capital to fund something that requires an upfront payment -- if you can easily pay it off with your budget over a short period of time (typically between one and seven years).

However, before you apply, you should learn the basics so you can find the best loan for your situation, as well as have a repayment plan in place.

About the Author: Catherine is the senior editor at Earnest, where she works with national financial experts and innovators along with Earnest's data science team to tell stories about new-fashioned finance. Before joining Earnest, she worked at the automated investing service Betterment.

Prior to that, Catherine spent a decade in journalism with jobs at Associated Press, Wall Street Journal, and Huffington Post. She graduated from Stanford University and studied journalism at the Columbia University Graduate School of Journalism. Her passion is for consumer advocacy and empowerment through better information and technology. You can read more of Catherine's work on Earnest's blog.

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