What to know before taking out a personal loan (2023)

Qualification criteria

Unfortunately, not everyone can qualify for a personal loan. Approval for a personal loan requires a stable source of income and a good credit history. Lenders also evaluate your debt-to-income (DTI) ratio, which is your monthly debts added together, divided by your monthly gross income — lenders generally like a percentage of 36% or less.

“Before applying for a loan, you want to review your credit report for mistakes and past issues and understand your credit score,” explained Dean Kaplan, president of The Kaplan Group, a commercial collection company based in San Luis Obispo, California.

“Look at your debt-to-income ratio and debt utilization ratio to understand how lenders will also be evaluating your financial situation and how that affects the interest rate you will be quoted.”

Going through a lender’s pre-qualification process can tell you upfront whether you’ll be eligible with that lender. You input a few personal details, and the lender comes back with a quote that includes your potential interest rate, borrowing amount and repayment term — without an impact on your credit score.

» MORE: How to check your credit score

Interest rate

The interest rate is the percentage charged by a lender for borrowing money. It’s expressed as a percentage of the loan amount.

You’ll likely see both an interest rate and an annual percentage rate (APR) on personal loans. The APR includes interest as well as fees. It represents the true cost of borrowing and is one of the most crucial factors impacting the total amount you’ll repay over the loan term.

Because APR has such an impact, shopping around and comparing lenders is essential. A small difference in rate can equal hundreds — possibly thousands — in additional costs over the life of a loan.

No matter which lender you go with, one of the factors that will determine your rate is your credit score. As such, focus on improving your credit score as much as possible before taking out a loan. Pay off existing debt or get errors removed from your credit report.

You can also add a co-signer to a loan — for example, if the co-signer has a stronger credit profile than you do. This can improve your chances of getting approved and get you more favorable loan terms, too. But keep in mind your payment activity impacts the co-signer’s credit as well.

» MORE: Best personal loans with a co-signer

Repayment term

The length of repayment for a personal loan, also known as the loan term, refers to the period of time in which a borrower must repay the loan in full. It is usually expressed in months or years.

The loan term is another major factor when calculating your monthly payment and has a significant impact on the overall cost of the loan. That’s because shorter loan terms generally mean a higher monthly payment. However, you also pay less interest over time.

As a borrower, you have to balance the monthly payment that works for your budget against the overall cost of the loan.

“The biggest thing to consider when borrowing money is your ability to pay it back. There is no point in acquiring something if you can’t afford to pay for it. That creates financial stress, could negatively impact your credit report and restrict your purchasing options at a later date,” said Kaplan.

“It’s important to do a budget including all income and expenses to understand how much money you have available for loan repayments. It’s important to look at your current situation and also your future needs. If you are planning to buy a house, getting an expensive car may be affordable but then restrict your ability to get a mortgage loan at a later date.”

» MORE: What are loan terms?

Additional fees and charges

The loan principal and interest charges represent the largest portion of your payment, but these aren’t the only costs involved in a loan. Lenders often include other fees, which can end up inflating the borrowing cost even more or pushing it out of your budget.

Additional charges may include fees such as:

• Origination fee: A one-time fee charged for the entire processing of the loan, including application, underwriting, funding or other administrative services
• Prepayment penalty: A fee the lender may impose if you pay off the loan early or make extra payments beyond the agreed schedule
• Late payment fee: Applies if you make a payment after the due date
• Returned payment fee: A fee for unsuccessful or bounced payments
• Annual fee: An annual charge for maintaining certain types of loans, which is more common in credit lines
• Application fee: Covers the cost of processing the loan application
• Underwriting fee: A fee for the lender's evaluation and approval process
• Appraisal fee: For loans tied to assets, such as real estate, a fee charged to determine the value of the collateral
• Credit report fee: A charge for obtaining and reviewing your credit report during the loan approval process
• Wire transfer fee: A fee for facilitating the transfer of loan funds to your bank account

Other options

A personal loan may not be the only option if you need funding. As you decide what borrowing option suits you best, evaluate how much you truly need — if any at all. Plus, think about any long-term impacts borrowing may have on your finances.

Credit cards

For smaller, short-term expenses, using a credit card is one alternative. You might have the option of taking advantage of a 0% promotional APR or balance transfer, so you can save even more on interest.

Home equity line of credit (HELOC)

If you own a home and have built up equity, you can borrow against it with a HELOC. As an added bonus, these typically have lower interest rates than personal loans. The downside is your home serves as the collateral, meaning the lender can take it if you default.

Family and friends

Borrowing from friends or family is another possible option. However, before proceeding, you should establish clear terms and repayment plans so you limit any potential conflict or strain on your relationship.

Savings

If you have funds available in savings, you may want to consider using them to help with an essential expense. Plus, you can avoid paying any interest charges or other lender fees.

Bottom line

A personal loan may be an ideal way to borrow money quickly to pay for your immediate needs. It may make sense to turn to this type of loan if you have good credit and are confident you can make the payments on time — and that you can repay the loan in full by the end of the loan term.

It may be more difficult for those who have poor credit to get a personal loan. If you do qualify, be sure the APR is reasonable and that you can afford to make the monthly payments. Otherwise, these loans can get costly quickly, and your credit can suffer.