Personal Loans: How They Work and What to Avoid

There are instances when you need cash to achieve financial goals, such as funding a home renovation, paying off credit card balances, and financing unexpected expenses. One way to solve financial problems is through personal loans.

How Do Personal Loans Work?

A personal loan is simpler and has better rates than a credit card. There are many financial institutions offering this type of financial product. You can apply for one at a bank, through an online lending company, or credit union.

The best thing about a personal loan is that you can use the borrowed money on any expense and it is payable over a predetermined amount of time. However, some lenders don’t allow the use of the borrowed money for college expenses and business purposes. During its term, you need to make monthly payments on the loan for the principal, fees, and the interest.

Fixed Terms and Interest Rates

A typical loan has a fixed term and interest rate. A fixed term means that you know when you will complete the payments for the debt. These terms are usually less than five years. While most lenders don’t charge prepayment fees if you pay the loan off early, some creditors do. Make sure you check the contract for an explanation of fees and other conditions.

A fixed interest rate means it stays the same throughout the lifespan of your loan. That means the amount you pay each month remains the same throughout its term. When signing up for a personal loan, make sure that you compare these aspects in offers from various lenders before making a decision.

Factors Lenders Consider When Approving Personal Loans

There are several factors just right loans lenders consider when approving personal loans. The first one is your credit score. The higher the score, the more likely you are to get an approval for a loan at a lower interest rate. This is because most consumers with high scores have a history of paying on time.

Another factor is your debt-to-income ratio. While the passing ratio differs from one lender to another, most lending companies set the limit to no more than 43 percent of the borrower’s monthly income.

Common Traps to Avoid

While personal loans can help solve financial problems, there are some traps that you need to avoid when signing up for one. It is important that you are aware of these pitfalls to ensure you get the best deal on the market. Here are some of the potential problems you might encounter:

1. Insurance

Some lenders offer insurance when closing the deal. Two of the most common types of insurance they offer are unemployment and life insurance. You likely don’t need them, especially if you already have an insurance policy.

Some people think unemployment insurance is good because it ensures they can continue to make debt payments if they lose their job. There are some people who benefit from this type of policy. However, you should consider how much you are paying for it. If you are not at risk of losing your job in the next six to twelve months, it is usually better to save the money instead of paying for insurance.

Life insurance promises that your family doesn’t need to worry about your debt when you die. However, lenders often offer bad policies that only milk money out of their clients. What you should do is to look for a good term life insurance that covers all your needs, not just the personal loan.

2. Origination Fees

Most people choose personal loans because they provide quick access to funds when they need them the most. If you borrowed the exact amount needed, you might be surprised to get less than that amount in the contract due to origination fees.

Origination fees are processing fees that depend on the borrower’s credit score, loan eligibility, and tenure. They are common among lending companies, and you might find it hard to find a lender that doesn’t charge one. If you need all the money you are borrowing, consider incorporating the fee into your computation. If the final borrowed amount is higher than what is required, at least you are getting the money needed, less the fee.

To avoid this pitfall, inquire about charges and fees and look for lenders offering the lowest processing fees. Most lenders impose an origination fee of 2 to 5 percent of the borrowed amount. Some lenders can offer lower fees if you have a good credit score.

3. Prepayment Fee

Most lenders allow prepayment of personal loans. This means you can prepay the debt whenever you come up with enough funds and get rid of the financial burden before the term ends. In the past, lending companies regularly charged for prepayments. Things changed in recent years, and only a couple of lenders still collect this type of fee. However, it is still best to look at the contract to find out which fees are collected by the creditor.

4. High-Interest Rates

Interest rates often depend on your credit score. A high rate means you pay more monthly. This is one of the reasons why it is advisable to shop around before applying. Lenders often charge interest rates as high as 36 percent to consumers with poor credit. If you have a bad FICO score, use a credit card instead of taking on a personal loan.

5. Pre-Compute Interest

Speaking of interest, lenders also try to trick borrowers with pre-compute interest. With this practice, the creditor computes the total interest the borrower will owe up front and adds it to the loan amount. As a result, even if you pay the debt early, you are still paying the interest for the complete term.

Always Do Your Research

Personal loans can help you in times of need. They are a great tool if you do your research first. Make sure you avoid traps at all costs. You should also avoid offers that are too good to be true. Chances are, they are just marketing ploys to lure potential borrowers into a trap. By playing it smart, you get to enjoy the benefits of personal loans without paying extra for them.


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