Personal loans can help you access flexible financing that you can use for many purposes: making a large purchase, financing home improvement projects, paying for unexpected expenses, or consolidating debt, to name a few. Other reasons could include financing a wedding, covering moving costs, or funding your dream vacation.
There’s a lot to understand about how these loans work, what uses and restrictions they come with, and which type of personal loan is the right fit for you.
What Is a Personal Loan?
A personal loan allows you to borrow a lump-sum of money that is repaid in monthly payments, or installments, over a predetermined term with a fixed interest rate. This makes it a useful financing option for a wide range of uses.
A few important characteristics of a personal loan include:
- Versatile financing: Personal loans offer a solution to finance a wide range of needs
- Secured or unsecured: Personal loans may either be backed by collateral (secured) or issued without collateral obligations, based on a strong credit history (unsecured)
- Tailored options: Interest rates, fees, loan amounts, and repayment terms can vary between lenders, giving you options to help you find the loan that best fits your needs
How Does a Personal Loan Work?
Unlike a credit card, which offers ongoing access to funds through revolving credit up to your approved limit, a personal loan gives you a lump sum of cash up front that is repaid in fixed, monthly installments. These are issued via lenders, including banks, who perform a review of your creditworthiness and other parts of your financial history. This information helps the lender determine your eligibility and loan terms, including your interest rate.
Common Uses for Personal Loans
Personal loans are a versatile financing option. Many people use personal loans to pay-off high-interest debt like credit cards and consolidate the debt into a single payment, which can potentially save you money in interest and simplify your finances.
People also use personal loans to fund major purchases they may not have the liquidity to finance outright, such as appliances, home improvements and renovations, or other big expenses. Some might use a personal loan to finance medical debt or cover other unforeseen emergencies. Others may use a personal loan to fund a wedding or vacation.
Restrictions on Personal Loans
Although personal loans can be utilized for many purposes, they do have some potential restrictions, such as using the funds for post-secondary educational expenses or down payments on real estate. This is because there are more specific loan options for those goals, and their terms and interest rates may prove a better fit. To ensure your funds can be used for your intended purpose, it's a good idea to ask a lender about any potential limitations or other appropriate borrowing options before applying for a personal loan.
Types of Personal Loans
Personal loans come in two main forms: secured and unsecured. Each has different characteristics and requirements.
Secured Personal Loans
Secured loans require collateral, such as a car or savings account. If you fail to repay the loan, the lender can take the collateral as a means to settle the unpaid debt. Since lenders take less risk with a secured loan, they often come with lower interest rates. In some cases, lenders will require borrowers with less credit history or lower credit scores to opt for secured loans in order to reduce the lender’s risk.
Unsecured Personal Loans
Unsecured loans don't require collateral. Instead, approval is based on your creditworthiness, including your credit history and credit score. Potential borrowers with better credit history may have a higher chance of getting approved an unsecured loan, since they demonstrate a strong record of financial responsibility to lenders.
Applying for Personal Loans
There are several factors lenders take into consideration when it comes to your application process for a personal loan. These help your lender understand your history with credit, your ability to pay off the loan, and how much debt you already carry.
Application Process
Personal loans are available through a few different avenues, including traditional financial institutions, such as banks, and online lenders. Those offering personal loans often have similar application processes, requiring you to gather documentation and meet qualifications. The lender then makes a decision on your application based on the information you supply. Depending on the lender’s process and requirements, the decision time will vary from lender to lender.
The Role of Credit Scores in Approval
Credit scores are one of the biggest factors in loan approval. No single credit score will guarantee lender approval but, in general, higher credit scores make approval for a personal loan more likely. A credit score is a universal benchmark with a maximum score of 850. The higher your number, the better your creditworthiness, and the more favorably your application will be viewed. Additionally, applicants with better credit may be more likely to secure better repayment terms and lower interest rates.
Credit History and Debt-to-Income Ratio
In essence, your credit history tells a story of your financial responsibility with past debt obligations. This includes credit card payments and other loan payments. Lenders evaluating your loan application want to see past payments made in full and on time. Lenders also look at your debt-to-income ratio, which compares your monthly earnings to the amount of debt you currently carry. To a lender, a lower ratio indicates you'll be better able to manage your personal loan payments.
Documentation and Other Common Personal Loan Requirements
Lenders may also request various other documents, including your past tax returns, bank statements, and personal identification. They may also ask you why you are seeking a personal loan.
Advantages and Disadvantages of Personal Loans
There are potential advantages of personal loans, but there are also other considerations you should know about before seeking financing.
Pros of Obtaining a Personal Loan
Personal loans will give you the cash you need to make purchases, handle expenses, or pay off some types of debt. Even if you have savings, a personal loan may be a good way to make a purchase without having to deplete your savings. Additionally, if you are consistent with loan payments when they are due, personal loans can help you build good credit over time.
Potential Drawbacks and Risks
Like any type of financing, you must be able to stay on top of payments, making them in full and on time. If you default on your loan — meaning you are not able to pay back your lender each month — your credit score will fall. Further, if your loan is secured you risk seizure of your collateralized property.
What to Do If You Are Denied for a Personal Loan
Not everyone who applies for a personal loan will be approved. In some cases, potential borrowers may not have long or strong enough credit history, too low a credit score, or may be carrying too much other debt, especially relative to their income or the total credit they have available.
If you are not approved, you can seek other financing options, or you can work to build stronger creditworthiness over time and reapply.
Alternative Financial Solutions to Personal Loans
In addition to personal loans, there are other available options that may meet your needs for financing. However, note that they have different terms and conditions compared to personal loans, each with their own potential features that should be taken into consideration when exploring borrowing options.
Credit Cards
Credit cards also provide financing up to your approved credit limit. However, this maximum amount is smaller than a personal loan, and the interest rate is often much higher. At the same time, a credit card can provide at least some access to capital to help finance purchases.
Personal Line of Credit
A personal line of credit is similar to a personal loan in that you can access financing to make purchases — but it is structured differently. With a personal line of credit, you don’t receive a lump sum of cash. Instead, you “draw” against a total credit line on an as-needed revolving basis much the same as a credit card.
Equity Loans and HELOCs
If you own your home, both home equity loans and HELOCs can help you access capital by leveraging the equity in your home to secure financing.
Conclusion: Is a Personal Loan Right for You?
Personal loans are popular for a reason — they offer flexible, convenient financing that can help you pay for some of your biggest expenses. If repaid on time and in full, they can also help you improve your credit score. With that in mind, they also require financial responsibility, so it’s important to fully assess your financial situation before applying. PNC can provide you with the information and guidance you need to make an informed decision.
