Personal loans are nothing new, but consumers are borrowing with them at an explosive rate. According to the credit reporting agency TransUnion, the number of new personal loans grew at over 20 percent per quarter during the past year. Much of that growth is a result of technology-focused lenders, who lend to a broad range of borrowers, including those with less-than-perfect credit.
As borrowers flock to these loans, you may wonder what makes personal loans so appealing and what tradeoffs (if any) exist when you borrow with personal loans.
What is a personal loan?
A personal loan is a loan that you qualify for entirely by your creditworthiness. Unlike secured loans, such as auto and home, you don't pledge any collateral to get approved for a personal loan. Instead, lenders examine your credit history, your income, and other factors when evaluating your application. Some people call these loans “signature loans," because your promise to repay is all you provide to lenders.
Different types of credit history is used by different lenders
Because lenders have little recourse if you stop paying, they typically approve borrowers with a history of borrowing and repaying loans. Traditionally, lenders have used credit scores (like the FICO credit score), but they increasingly use alternative sources. For example, they might review your history of utility payments, your college degree, or other factors.
Repayment terms are often short
Personal loans come in a variety of forms. Standard personal loans are installment loans that you pay off over time with fixed monthly payments, although some loans have variable rates. Terms are often three to five years, but longer and shorter terms exist.
Interest rates can be high
Because there's no collateral to secure a loan, lenders set rates primarily based on your creditworthiness. Borrowers with excellent credit qualify for the lowest rates, which are typically slightly higher than rates on secured loans. Those with poor credit or a “thin" credit history pay rates similar to those available from credit card issuers — which can get quite expensive. For example, some of the largest online lenders offer loans with rates of 29 to 35.99 percent APR.
Origination fees should be expected
Some lenders charge origination fees when issuing loans. For example, a local credit union might charge a fee of $100 or so, and some of the largest online lenders charge fees ranging from 1 to 6 percent of the amount you borrow. Those fees increase your cost of borrowing, and it's critical to compare offers from several different lenders to get the best deal.
The appeal of personal loans
Personal loans are attractive to borrowers who want to borrow for a short period. These loans are relatively low-risk for borrowers who don't need to pledge collateral to get approved — and those who have no collateral. Of course, a low risk for borrowers means the opposite for lenders, who need to screen borrowers carefully or charge higher rates to manage their risk.
Quick and easy
Personal loans are relatively painless to apply for. Borrowers can typically complete the process online, and they don't need to submit a mountain of paperwork to lenders like they might with a traditional mortgage loan. As a result, approval and funding are quick.
No restrictions on use
You can use a personal loan for almost anything you want. For better or worse, lenders will give you money to use however you choose, including everyday expenses, vacations, home improvement projects, debt consolidation, and more. Ideally, you would use the money to make significant improvements to your life (not to sustain high spending levels), and you pay off the debt within a few years.
Interest rates are usually better than credit cards
When the only alternative is a credit card with exorbitant rates, personal loans can be appealing. According to the Federal Reserve, the average interest rate on credit cards nationwide was 14.22 percent at the end of 2018. But those who pay interest on their cards — who are actually borrowing instead of paying off the balance every month — pay 16.04 percent. Compare that to the Fed's reported rate of 10.32 percent on 24-month personal loans, and the personal loan looks a good option.
Personal loans have been a hot item lately. According to TransUnion, personal loan balances reached a record-high $138 billion at the end of 2018. Financial technology (FinTech) lenders now account for 38 percent of personal loan balances, compared to just 5 percent of those balances in 2013.
Part of the growth comes from FinTechs lending to borrowers with less-than-perfect credit. Traditional banks and credit unions might be reluctant to approve applications from those borrowers, but new lenders are willing to offer unsecured loans to so-called subprime borrowers.
Pitfalls of unsecured loans
While personal loans can work well for short-term borrowing, they must be approached with care. Before you borrow, get familiar with some potential drawbacks of using a personal loan.
Personal loans can have high interest rates and fees. Unless you have excellent credit, you probably won't qualify for the best advertised rates. What's more, origination fees (the cost of processing the loan) add to your total cost of borrowing, and there may be more economical choices available. Finally, although rare, some lenders impose prepayment penalties, so it's critical to read loan agreements carefully.
Lenders may limit unsecured loans to relatively small amounts. They have no guarantee that you'll repay, so it's unwise for them to lend too much. As a result, you might not be able to borrow as much as you need for significant projects or debts.
Possibly too easy to take
Much of the growth in personal loans is in the subprime market. Those borrowers are the least able to absorb monthly payment increases and unexpected life events. Just because you can borrow with a personal loan doesn't mean you should, or that you're doing any better than you would with a credit card. If you're unable to afford the payments, your credit may suffer, making it harder to get approved for essential loans like home and auto in the future.
If you have equity in your home, a home equity line of credit may be a better solution. You can borrow significantly more, and you might be able to pay a similar amount (or less) in origination fees. Perhaps most importantly, you'll almost certainly get a lower rate. The benefits of a low rate are significant:
- You pay less interest over the lifetime of the loan
- Because interest rates affect your payment, you should have a lower monthly payment with a home equity loan, all other things being equal. But you can pay more if you want to, and those extra payments accelerate the process of eliminating debt
There's still an application process, but some lenders make it easy. Figure provides an entirely online application, that takes just a few minutes, and will deposit your funds in as little as five days2.
If you're intrigued by personal loans, compare those offers to alternatives like home equity loans. With a little bit of research, you can arrive at a solution that works best for you.