What to know before taking out a personal loan

In need of a financial cushion? You may be considering a personal loan — these loans typically don’t require collateral and can be used for just about anything, so they’re a popular option. A personal loan can help you meet emergency expenses, cover a home repair or help you get caught up on your debts.

Before you decide to take out this kind of loan, however, it’s important to grasp how they work, what you need to qualify, the types and how to find the best lenders. 

1. How personal loans work

A personal loan is usually an unsecured loan, which means you don’t have to provide collateral to secure the loan. This type of loan carries more risk for a lender because there are no assets to seize (e.g., car, house, savings) if the borrower defaults.

Most lenders require borrowers to have sufficient income to repay their debts. Unsecured personal loans have stricter credit requirements than secured loans. Repayment terms typically range from a few months up to five years and have set monthly installments throughout the course of the loan.

Personal loans tend to have annual percentage rates (APRs) ranging from 3% to 35.99% (avoid those with APRs of 36% or more if possible — this can be a sign of predatory lending). Rates range based on credit, income, debt-to-income (DTI) ratio and other factors.

2. Types of personal loans

There are multiple types of personal loans. Though most personal loans are unsecured, some do require collateral. You should consider both secured and unsecured personal loans to determine which may work best for you. Secured loans, which are often backed by a high-value asset, like a car, may have a lower interest rate. However, you’ll be at risk of losing your asset if you default on the loan.

Unsecured loans are more common. The tradeoff for putting down no collateral is paying a higher interest rate.

Personal loans may also have a fixed or variable rate. A fixed-rate loan will have the same annual percentage rate (APR) throughout the life of a loan, which keeps your payments consistent and simplifies your budget. A variable-rate loan may change if federal interest rates rise or fall, which adds more unpredictability to your payments.

3. Your credit score, income and DTI

Before you apply for a personal loan, it helps to assess your financial health. To start, make sure you know what your credit situation is. You can access your credit report using annualcreditreport.com — this site provides access to free TransUnion, Equifax and Experian reports once annually. Check your reports for accuracy and your scores to make sure everything looks correct.

The better your credit score, the lower your APR is likely to be. Also, note that taking out a personal loan will likely temporarily lower your credit score a few points because the lender will perform a hard credit inquiry. If you make on-time payments consistently, your score will go back up. If you miss payments or fail to repay your loan, you can expect an additional drop in your credit score. 

It's also important to know what your total annual income is, as well as your debt-to-income ratio (DTI), or the amount of monthly debt you have compared with how much money you make. Lenders typically want to see a DTI below 35% to 40%.

4. Where to get a personal loan

In general, you can get a personal loan from a bank, credit union or online lender.

If you have a bank you use already, it may have personal loan options for you — especially if you have good credit. Banks do tend to require more documentation to apply than some other lenders, however.

Credit unions tend to have some of the best interest rates for personal loans — mainly because they’re member-focused not-for-profit organizations. If you’re part of a credit union, this may be the way to go, but you can also look for credit unions you’re interested in and discuss the requirements for personal loans, including how to become a member.

Many online lenders offer flexible borrowing terms, interest rates and conditions. Just make sure you do your homework to find the best lender for you based on cost, availability and lending power.

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.