A personal loan is a personal financing option. It lets you borrow a lump-sum amount for various purposes, typically with a fixed interest rate, fixed monthly amortizations, and a short repayment period.
Personal loans may be secured or unsecured. Moreover, personal finance pricing varies depending on several factors.
Through a personal loan, you can get a lump-sum amount from your bank or lender. Thus, a personal loan is unlike a line of credit where you get a maximum credit limit instead of a lump-sum disbursement.
Maximum Loan Amount
The lump-sum amount of money you can borrow depends on several factors. For instance, if the loan is unsecured, the lender will base the maximum loan amount on monthly salary or verifiable monthly income.
The maximum loan amount available to secured personal loans is typically higher than that of unsecured personal loans. In unsecured loans, lenders determine the maximum amount based on the value of the loan collateral.
Actual Loan Amount
Note, however, that the maximum amount is just that – a ceiling or an upper limit. The actual lump sum amount you can borrow will vary according to many factors, such as your credit score, your monthly salary, and your debt burden.
By the way, the amount of money borrowed is called the principal.
Personal Financing Purpose
Personal loans are generally versatile instruments because you can use them for a variety of purposes. They are different from a student loan or a mortgage, which you use to pay for tuition or a home purchase, respectively.
You can use it for medical expenses. Personal loans are also a popular debt consolidation option. Others use it on home renovations or vacations, while some use it to finance their grand marriage proposal or wedding.
However, personal loans may have a use-case restriction. Some banks won’t accept personal loan proceeds as a home or car purchase down payment.
A down payment is an equity investment by a home or car buyer. In other words, a down payment gives a customer a stake in the property he is buying. Thus, it does not make sense for a bank or lender to provide the money for it.
Fixed Interest Rate
Most personal loans have fixed interest rates. In a fixed-rate personal loan, the interest rate will not change throughout the life of the loan. In the less common variable-rate personal loan, the interest rate varies according to market rates (and thus market conditions).
The interest is the amount a bank or lender charges on the amount you borrowed. It is the cost you pay for borrowing money or the profit the bank or lender makes for lending you money.
Lenders charge interest on a per-annum basis. The annual interest rate and other charges determine the annual percentage rate.
Fixed Monthly Amortization
Fixed-rate personal loans provide an easy-to-follow monthly amortization schedule. The monthly installment does not change from month to month for the entire duration of the loan term. This makes a fixed-rate personal loan easier to manage.
Note, however, that your monthly payments are typically not applied to your loan the same way throughout the loan term. Initially, a considerable proportion of your installments go to interest payments rather than being deducted from your principal.
In the less common variable-rate personal loan, your loan amortization may vary monthly. Monthly amortization amounts will depend on the prevailing applicable interest rates for that payment period.
Personal loans are usually short-term loans, and typical loan terms range from 12 to 60 months. Rarely do personal loans go beyond this term. But it is possible depending on applicable banking laws, bank or lender policies, and your relationship with the lender.
Secured or Unsecured
Most personal loans are unsecured loans, so they are not secured by assets or any collateral. However, lenders typically protect themselves from default by lending only to salaried customers or those who have regular business income.
In unsecured loans, the lender may require you to execute an agreement that will let it deduct your monthly amortization directly from your salary.
Although rare, there are secured personal loans, too. Secured personal loans typically offer better terms than unsecured personal loans. They may offer higher loan values, longer terms, or lower interest rates.
Factors That Affect Personal Finance Pricing
How much effective interest will you pay on your personal loan? Personal finance pricing varies according to the type of loan, the provider, your credit score, and the loan term, among other factors.
1. The Type of Loan
As mentioned above, secured loans are likely to have more favorable pricing than unsecured loans. Personal lines of credit also have a different pricing scheme.
In a personal line of credit, interest is charged only when credit is used, and it is computed only on the actual amount of credit utilized. In a personal loan, however, the interest is charged outright against the principal.
2. The Provider
Different banks offer different interest rates and, consequently, different annual percentage rates and effective interest rates.
How does a bank, credit union, or lender calculate personal loan pricing or the interest rate it will charge for a personal loan? While lenders may consider similar factors, they may give each one a different weight in their calculations.
Digital financing companies or purely online lenders, moreover, may also have a non-traditional approach to personal finance pricing. For instance, some use machine learning technologies to assess loan applications.
3. Your Credit Score
Of course, lenders will consider your credit score when calculating the effective interest rate on your loan.
Your credit score is your numerical credit rating provided by one or more credit reporting agencies or credit bureaus. Credit bureaus calculate this using many factors such as your credit history and debt burden, among others.
Have you taken out a loan before? How much was the loan? Have you fully paid for your past loans? Were you ever late paying your loan amortizations?
The number of credit inquiries made against your credit record also affects your credit score. An inquiry is essentially a request by an institution for your credit information.
This statistic typically indicates how often you have attempted to apply for a loan. The more inquiries made, the more attempts to borrow. Thus, frequent credit inquiries will negatively affect your credit score.
Lenders learn about your debt burden from your credit report. The debt burden pertains to the percentage of your monthly income that goes to debt servicing. The greater your debt burden, the higher the risk for the lender.
A high debt burden will hurt your credit score.
4. Loan Term
The loan term also affects your loan pricing. The longer the loan payment term, the lower the annual interest rate is likely to be. Because the longer you repay a loan, the more sizable your total interest payment will be.
Before Your Finance: Stop and Look, Then Carefully Choose
Personal financing schemes like personal loans fill the need for easy-to-obtain short-term or emergency funding. Personal loans are versatile; use them for almost any purpose. They are straightforward, too, with their set loan amounts, fixed loan terms, and manageable monthly installments.
However, personal loans are not the only type of financing available, and your alternatives may or may not be more appropriate to your needs. Therefore, never take out a personal loan – or any loan for that matter – without thoroughly checking all of your options first.