What You Should Know Before Taking Out a Personal Loan

There’s a lot to know when seeking a personal loan. For example, how is a personal loan different from more familiar types, like auto loans and mortgage loans? What can you use personal loans for? Are there any alternatives to personal loans?

To get the answers to these and other questions, Investopedia spoke with Linda M. Hooks, head of the Department of Economics at Washington and Lee University in Lexington, Virginia. In addition to leading the largest department at Washington and Lee, Dr. Hooks has conducted and published research in a variety of economic areas. Our edited conversation follows.

How Personal Loans Differ from Other Types of Loans

Investopedia: "For starters, what’s a personal loan, and how does it differ from other types of loans?"

Hooks: "A personal loan is a fixed-payment loan for an individual consumer. An individual borrows money now and repays it over a specific time period by paying the same amount monthly. In that way, it is similar to a car loan or a mortgage payment. It is different from those types of loans because it may not require collateral or an item of value, such as a car or home, that you agree to forfeit if you cannot repay."

Investopedia: "What can personal loan funds be used for?"

Hooks: "Personal loans are versatile. They can be used for purchases that are too large to buy with cash, such as a new appliance or air conditioner. They sometimes can be used for consolidating other debt. They can be used for one-time expenses such as medical bills, educational expenses, or perhaps a special trip."

How to Qualify for a Personal Loan

Investopedia: "What qualifications do you need to have to apply for a personal loan?"

Hooks: "As with most loans, the primary qualification is a good credit history. Sometimes, it may be possible to use collateral for a personal loan, and this may help to make you qualified for a personal loan or a better rate on the loan. Ask your bank what else might be accepted as collateral, such as savings accounts or an insurance policy."

Investopedia: "Where can people find out their credit score, and does it cost money?"

Hooks: "Generally, you can obtain a credit score only by paying a fee. However, you can obtain a free credit report from the website AnnualCreditReport.com. You can find additional information on this service, including a phone number and mailing address if you prefer to order a report that way, at the Federal Trade Commission website titled Free Credit Reports. The information in your credit report is the basis for the credit score, so you may not need to see the actual credit score as long as your credit report looks accurate."

Factors That Determine How Much You Can Borrow

Investopedia: "How do lenders determine how much people can borrow?"

Hooks: "To determine how much a person could borrow, lenders use the credit score along with other factors such as possible collateral or an already-existing financial relationship with you."

Investopedia: "What are some ways to improve your chances if you are not approved?"

Hooks: "If your application is denied, you have a right under federal law to know why it was denied. This can help you decide what to do next. Often, the denial is due to a low credit score, and you can work to improve the score. Some steps to improve your credit score include paying bills on time and paying the amount required, which is at least the minimum payment required on a credit card. You should pay more than that, if possible. Do not charge the maximum allowed by your credit cards, meaning keep the balance well below the maximum."

Early Payoff, Co-Signers, and Other Loan Options

Investopedia: "Can you pay a personal loan off early, or does that depend on the terms of the loan?"

Hooks: "Early repayment of the loan might be possible, but it does depend on your specific loan. Ask before you sign the loan documents if there would be any penalty associated with early repayment."

Investopedia: "What is a co-signer, and when might a borrower need one?"

Hooks: "A co-signer is someone additional who agrees to repay the loan if you cannot. Having a co-signer can help someone with a limited credit history to obtain a loan. However, the co-signer should be aware that they are liable for the loan in the same way that they would be if it were their own loan. It may also affect the co-signer’s credit history and score."

Investopedia: "What are some alternatives to a personal loan?"

Hooks: "Alternatives to a personal loan might include a home equity loan or a credit card. Another alternative, if it is a planned expense, is to save up for the purchase and buy it only after you have saved the funds for the item."

Protections Available to Borrowers

Investopedia: "Where do you go to complain if you feel your lender is doing something illegal or wrong?"

Hooks: "The Consumer Financial Protection Bureau (CFPB) was established under the Dodd-Frank Act of 2010 to provide consumers with resources and an avenue for complaints about financial services."

Investopedia: "What happens if you have financial problems and can’t make loan payments?"

Hooks: "If you run into financial problems and feel you would have trouble making a payment, contact your lender as soon as possible. There may be federal government programs that can help you as well, and you could find information on that on the CFPB website."

The Bottom Line

Personal loans offer flexibility for purchases that might not fit into a purpose-built loan, such as an auto loan or mortgage. Personal loans can be obtained relatively quickly, and with a good credit history, they can have lower rates than a credit card. However, personal loans can be fairly expensive if you have bad credit. Carefully consider your long-term financial goals before taking out a personal loan. In the long run, saving up for your big expenses may be a wiser move.