Personal loans can be an affordable financing option for major expenses and debt consolidation, but misconceptions around how they work may prevent some people from taking advantage of them. These misunderstandings could also lead to unnecessarily high fees and interest rates.
Learning how a personal loan works could not only help you improve your financial situation, but it may also save you money along the way. Here are some common myths about personal loans, along with the real facts you should know before borrowing.
Most personal loans are unsecured, so they may have higher interest rates than a secured loan like an auto loan or home equity loan. However, personal loan rates can still be competitive, especially for borrowers with strong credit.
As of the time of writing, personal loan rates start around 6% to 8%. According to the Federal Reserve, the average rate on a two-year personal loan is 11.57%. That’s significantly lower than the average rate of 21.16% on a credit card.
Interest rates on personal loans typically max out at about 36%, which is still a lot lower than a payday loan. Payday loans, which usually require repayment on your next paycheck, can have rates and fees that add up to an APR of 400% or higher, according to the Consumer Financial Protection Bureau.
Many personal loan providers let you prequalify online, so you can see what rate you’re likely to get without impacting your credit score.
If you think a less-than-perfect credit score means you can’t get a personal loan, think again. Credit requirements vary widely among lenders, with some accepting subprime credit scores. These lenders often consider alternative factors, such as your income and employment, when evaluating your application for a personal loan.
Granted, you’ll probably end up with a higher interest rate if you have a weak credit score. You may also have to pay an origination fee, equaling up to 10% of your loan amount. But you may still get approved for the funding you need to cover an emergency expense, finance a major purchase, or consolidate high-interest debt.
Read more: Best personal loans for bad credit
Gone are the days of filling out endless paperwork at the bank. Personal loan applications can be completed online, and it often only takes a few minutes to apply. Some lenders can give you a same-day approval decision and disburse your funds the same or the next day.
Here’s how the process typically works: Once you’ve picked a lender, you’ll sign into the online portal to fill out an application. Along with providing your personal and financial details, you’ll upload some verifying documentation. This could include your identification, pay stubs, tax returns, and proof of address.
As long as you’ve fulfilled the personal loan requirements, all you need to do is wait for the lender’s approval and receive your money. The process is much more streamlined than applying for a secured loan, such as a mortgage, HELOC, or car loan. Gathering your documents ahead of time can also speed up the process.
Read more: How long does it take to get a personal loan?
You may be wary of online lenders that offer personal loans, but many reputable lenders operate online. In fact, some online lenders offer more competitive rates than brick-and-mortar banks, along with streamlined applications and fast funding.
That said, there are predatory lenders out there on the internet. Beware of companies that promise no-credit-check loans, for example, as they could charge exorbitant fees that make the debt difficult to pay off.
Stick with well-known, established lenders, and check out reviews on a site like TrustPilot or the Better Business Bureau to see what other customers have to say.
Read more: What’s the best place to get a personal loan?
A personal loan can help or harm your credit, depending on how you pay it back. When you first apply, the lender will run a hard credit inquiry, which can ding your score by a few points. Your score will usually dip by five points or fewer, and it should bounce back in a few months as long as you pay your loan on time.
Making regular, on-time payments on your personal loan should improve your credit score over time. Your payment history makes up the biggest portion of your FICO score at 35%. Late or missed payments, on the other hand, would hurt your score, so consider whether you can afford repayment before you borrow.
A personal loan may also help your credit score if you use it to consolidate credit card debt. A high credit utilization ratio can hurt your credit score, so experts generally recommend keeping it below 30%. Consolidating credit card debt with a personal loan could lower your credit utilization ratio and improve your credit score.
Read more: Does debt consolidation hurt your credit?
Personal loans are flexible forms of financing that can be used for almost any expense, including major purchases, home renovations, medical bills, car repairs, and debt consolidation.
However, lenders set restrictions on how you can use the money. Many lenders don’t let you use the funds for college tuition, while some won’t let you use a personal loan for business. Plus, you generally can’t use a personal loan for gambling, investing, a down payment on a mortgage, or any illegal activities.
When you apply, a lender usually asks you to describe the purpose of your loan to ensure it meets its guidelines. Be honest, as any incorrect information on your loan application could be considered fraud.
Read more: Can I use a personal loan for anything? 6 expenses that are restricted.
Most personal loans are unsecured, so you don’t have to pledge an asset as collateral. Because they’re unsecured, a lender bases its approval decision on your financial profile, including your credit, income, and employment.
That said, some lenders offer secured personal loans that you can back with collateral, such as a car, savings account, or fixtures in your home. You may qualify for a larger loan amount or better interest rate if you opt for a secured personal loan.
The potential downside is losing your collateral if you default on a loan. If you’re concerned about your ability to qualify, another option may be applying with a creditworthy co-signer or co-borrower.
Taking out a joint personal loan may help you get a better rate. Just keep in mind that both applicants’ credit scores will be impacted by the loan, and you and your co-borrower share equal responsibility for paying it back.
Personal loans can be useful for financing a variety of purchases or accessing funds in an emergency. They’re also helpful for consolidating debt at a potentially lower interest rate.
Before you borrow, it’s essential to shop around with multiple lenders. The prequalification process is quick and won’t impact your credit, so you can gather offers before you commit.
As you review options, consider the loan’s interest rate, repayment term, and monthly payments, along with any fees. Depending on the lender, you may get to choose terms of one to seven years or longer.
Personal loans can support your financial goals when used wisely. By clearing up any misconceptions, you’ll be able to borrow responsibly and determine if a personal loan makes sense for your situation.
This article was edited by Alicia Hahn.
