Should I get a personal loan?

What is a personal loan?

A personal loan is money borrowed from a financial institution and can be used for almost any purpose, including the following:

• Debt consolidation
• Medical bills and emergencies
• Home renovations
• Vacations
• Wedding
• Funding your small business goals

It is an installment loan, which means that the lender gives you a set amount of money as a lump sum, and you repay the loan with interest over a fixed period of time. Lenders charge interest and other fees, including origination fees, to cover the processing of the loan.

Many lenders report payment activity to the three main credit bureaus, so getting a personal loan may also help you build good credit if you make payments on time each month.

» MORE: 4 best low-interest personal loans

Pros and cons of personal loans

Getting a personal loan may solve a short-term problem, but it's important to remember that payments may stretch out for years into the future.

“First off, ask yourself if the item you're taking a loan against is really a need. If not, then it's likely not worth the hassle of the debt and the additional interest you're going to owe on it,” said Derek Sall, the founder and lead at Life And My Finances. “If you're taking out a personal loan to pay off high-interest debt, that's a smart move, but be sure there isn't a prepayment penalty.”

Consider the pros and cons before taking out a personal loan.

Benefits of personal loans

• Fast funds: For eligible applicants, many lenders can offer preapproval and funding within a few days.
• Ease the debt load: Consolidating several debts into a personal loan makes repayment manageable and can help you get out of debt in less time.
• Possibly better rates than credit cards: Not only do most personal loans come with fixed, rather than variable, rates, but personal loans may have better annual percentage rates (APRs), depending on your creditworthiness.

Risks of personal loans

1. More stringent eligibility requirements: You will need a good to excellent credit score, verifiable income and low debt-to-income (DTI) ratio.
2. Missed payments costly: Unlike credit cards, there is no minimum payment option. Instead, you must make the full monthly payment on time or risk receiving a high penalty fee and a hit to your credit score.
3. Increased debt load: If you are using a personal loan to consolidate your debt, then you aren’t adding to your debt. However, if you are using a personal loan to cover wedding or remodeling costs, you are adding a costly debt bill to your budget.

How to qualify for a personal loan

Lenders typically look closely at your financial situation when deciding whether to approve your application for a personal loan. Your credit rating has a direct effect on your loan's APR, which is the annual cost of the loan, including interest and fees, expressed as a percentage of the amount borrowed.

Required personal loan documents

Lenders ask for documents and information before approving your loan. These can include:

Some lenders will not approve applicants with low FICO credit scores, no matter their income, employment or evidence of savings.

• Proof of employment: Lenders may want to see copies of your most recent pay stubs and a letter from your employer proving that you have a steady job.
• Tax returns: You may have to provide a copy of your tax returns to show that you have a reliable income that's large enough to afford the monthly payments for your loan.
• Other income sources: If you have investment income, earn money from a pension or receive Social Security benefits, you may have to provide proof of that income.
• Evidence of savings and cash: Lenders want reassurance that you have additional funds available to help you make monthly loan payments if your income decreases. They may ask you for recent bank statements showing that you have money set aside for emergencies.

» MORE: How to use a credit-builder loan to establish credit

Additional eligibility requirements

Lenders look at your credit history to determine whether you have a record of making on-time loan payments. Borrowers with higher credit scores generally have an easier time getting approved for personal loans.

FICO credit scores range from 300 to 850, with higher scores indicating better credit. Borrowers with credit scores in at least the "good” range (670 or higher) may qualify for personal loans with favorable terms more easily than those with credit in the "fair" or "poor" range (669 or lower).

Bottom line

Personal loans are an important financial tool that can help you save money on high-interest debt, make large purchases or finance other needs, such as remodeling your home.

Before getting a loan, be sure to check your credit report so you understand whether you're likely to be approved at a good interest rate with minimal fees.

While taking out a personal loan to consolidate high-interest debt may make sense, nonurgent expenses like a vacation may not always be good reasons for getting a loan. Consider your unique personal circumstances as you decide whether to take out a personal loan, and if you choose to move forward, be sure to compare offers from different lenders.