The personal loan as a credit instrument has been around for decades. It was very common, for example, in the days before everyone carried a credit card.
A personal loan is very different from an auto loan, in that it is only secured by your creditworthiness. With a car loan, the vehicle itself serves as collateral. That's why the interest rate on a car loan is typically much lower than the interest on a personal loan -- the risk to the lender is less.
That makes a personal loan more similar to a credit card, which is also unsecured debt. A personal loan could come in handy, however, if you are faced with an unexpected bill -- often the kinds of emergencies that send people to payday lenders, where the interest rate can be 400% APR or more.
How personal loans are used
Dan Matysik, Vice President of personal loans at Discover, says more consumers are using these loans to consolidate existing high-interest debt.
"Generally, an appropriate use for a personal loan is one which fits within the consumer’s budget and helps them achieve their financial goals," Matysik told ConsumerAffairs. "Regardless of how you plan to use a loan, there are a number of factors to consider when determining what type of loan best fits your needs. "
It starts with determining how much you need to borrow and the timeframe during which you can repay it. Next, Matysik says consumers need to consider the terms of the loan.
"With the loan options currently available, including from Discover, there is no need to pay origination fees, prepayment penalties, or closing fees," Matysik said. "These fees can significantly add to the total cost of the loan, and they can be easily avoided by choosing the right lender."
For example, Matysik says if a lender has a 5% origination fee, a $20,000 personal loan would cost the consumer an extra $1,000.
Check for fees
So, when researching lenders who offer personal loans, consumers should first determine if the loan carries fees and, if so, how much.
The interest rate may be a little lower than what you would pay on your credit card, but that's all going to depend on your credit score. The higher your score, the better your rate.
In selecting a lender, Matysik also says trust should be a big factor.
"Trustworthiness could be gleaned from, among other things, a lender’s stability and transparency in the lending process," he said. "It’s critical to research the lenders you’re considering and make sure they have a reputation for providing an overall positive customer experience."