If you’re going to apply for a personal loan — or just thinking about it — there are some things to take care of first, such as checking your credit, researching loan options, and determining what monthly payment makes sense for you.
By understanding how personal loans work and the process of getting one, you’ll be in a good position to find the best personal loan for you.
How do personal loans work?
A personal loan is an installment loan with a fixed interest rate — you receive it in a lump sum and then repay it in equal monthly installments, usually over a period ranging from one to seven years. The average annual percentage rate (APR) on a two-year personal loan was 12.33%, according to the Federal Reserve.
Personal loans are usually unsecured, which means you don’t have to pledge an asset like your car or home as collateral. As a result, the loan approval process can be quick, and you could be approved and get the funds as soon as the same day you apply, depending on the lender.
However, because there’s no collateral, the lender takes on more risk, which means a higher rate for you relative to secured loans like a home equity loan or auto refinance. Some lenders offer secured personal loans, which may be a good choice if you can’t qualify for a loan based on your credit score, income, or debt-to-income ratio (DTI).
Learn More: How Do Personal Loans Work?
Good to know
Secured personal loans come with more risk to you. If you can’t make your payments, the lender can seize your asset.
You can use a personal loan for just about any purpose. Popular reasons for getting a personal loan include debt consolidation, home renovations, large purchases, and covering unexpected or emergency expenses.
1. Check your credit score
Your credit score is one of the most important factors lenders look at when you apply for a personal loan. It helps determine whether you qualify for a loan in the first place, as well as the interest rate you’ll pay on your loan.
FICO credit scores range from 300 to 850 and fall into the following ranges:
- Less than 580: Poor
- 580-669: Fair
- 670-739: Good
- 740-799: Very good
- 800 or more: Exceptional
There’s no standard minimum credit score to qualify for a personal loan, but you have the best chance of qualifying if you have at least a good credit score. Additionally, while there are lenders that offer loans to borrowers with fair or poor credit scores, the best scores are generally available to borrowers with very good or exceptional scores.
There are plenty of apps that allow you to check your credit score at any time. Many credit card providers also offer credit score monitoring. If you find any errors when you check your credit, you can report them directly with the three credit bureaus: Equifax, Experian, and TransUnion.
Before applying for a personal loan, be sure to research lenders’ credit score requirements. Applying for a loan can temporarily reduce your credit score, and the last thing you want is to see your credit score go down after applying for a loan you aren’t approved for.
Check Out: How To Build Credit
2. Determine how much money you need
The next step of the personal loan process is deciding how much you need to borrow. When considering how much to borrow, there are several things to keep in mind.
First, think about how much you need to borrow. A personal loan is an installment loan, which means that once it’s approved and you receive the funds, you can’t get more without applying for a new loan. Because of that, it’s important to borrow enough to cover all of the costs.
On the other hand, you don’t want to borrow too much money. Keep in mind that every dollar you borrow will have to be repaid. And the more you borrow, the higher your monthly payments will be.
For example, if you borrow $10,000 with a three-year repayment term and an interest rate of 13%, your payments will be roughly $337 per month. But a loan with the same terms and an amount of $15,000 would result in monthly payments of nearly $170 more. That’s an extra $170 you’d have to make room for in your budget.
Not only that, but the more money you borrow, the more you’ll pay in interest over the life of the loan. In our example above, comparing a $10,000 to a $15,000 loan, the higher loan amount would result in nearly $1,000 more paid in interest over the life of the loan.
Ultimately, you must make sure the amount you request from a personal loan is high enough to cover the necessary costs, but not so high that it exceeds your ability to comfortably repay it.
Check Out: Personal Loan Term Length: What You Need To Know
3. Research lenders and loan options
Before applying for a personal loan, make sure to thoroughly research your loan options. There are many highly-rated personal loan lenders, and it’s important to find one that best meets your needs.
When choosing a lender, there are generally three types to choose from: traditional banks, credit unions, and online lenders. Each of these options has its own pros and cons. A traditional bank or credit union could be a good option if you already have a relationship with that financial institution, such as having your accounts there or having previously borrowed from them.
Online lenders also have some major advantages. Because they don’t have physical locations, their overhead tends to be lower, which can result in lower fees and interest rates for borrowers. Additionally, some have more lenient eligibility requirements and offer loans to borrowers with poor or fair credit.
It’s helpful to decide ahead of time what you need when it comes to your loan amount and repayment term, as well as your credit score and your desired APR. Knowing these factors upfront can help you narrow down your lender options quickly.
4. Prequalify with multiple lenders
Many lenders allow you to prequalify for a personal loan, meaning you’ll go through a soft credit check to determine whether you’re likely to qualify for a loan and what your estimated APR, amounts, and terms are.
Because prequalification doesn’t negatively affect your credit score, it presents an opportunity to shop around with different lenders to see which could offer the best option for you.
Tip
Once you move forward with a formal application, you’ll have to go through a hard credit inquiry that may lower your credit score temporarily.
5. Compare lenders
Once you’ve prequalified with multiple lenders, you’re almost ready to apply for your loan. You can take the loan offers you’ve received from each lender to decide which is the best fit.
Some factors to keep in mind when deciding between lenders are:
- Loan amounts
- Repayment terms
- APR
- Credit score requirements
- Income and DTI requirements
Check Out: What Is Debt-to-Income Ratio?
Tip
The annual percentage rate includes both the interest rate and any upfront fees, such as an origination fee, making it a more effective measure of a loan’s cost than the interest rate alone.
In most cases, the best lender is the one that offers the loan amount and repayment term you want at the best rate. However, don’t overlook fees. A high origination fee or other fees could overshadow small savings in interest, so it’s important to run all the numbers.
Check Out: Best Personal Loans With No Origination Fee