Frugal Living

Taking Out a Personal Loan – Here’s What You Should Know

Let’s face it; life can be expensive. There are times in everyone’s life where they need a lump sum of cash, and their savings aren’t going to cut it. Maybe you need to renovate your house or pay an unexpected medical bill? Perhaps you are planning a vacation for the family? If you are planning on taking out a personal, here’s what you should know. 

What Is a Personal Loan?

A person may seek a personal loan for a variety of personal reasons. The reason for your loan may be for debt consolidation or to buy that new car you have been dreaming of driving. 

Personal loans are often offered by financial institutions and paid in a lump sum and usually paid back in installments over an agreed-upon length of time. Generally, the borrower then pays back the loan at a fixed interest rate.

Are There Different Types of Personal Loans?

Personal loans come in the form of either secured or unsecured debt. Secured debt makes use of collateral that a borrower provides to secure the debt. This collateral may be any high-value asset in the borrower’s ownership from items of jewelry to vehicles in the case of online title loans.

They name this type of loan secured because should the borrower default on his/her loan, the lender has a legal right to claim ownership of the asset provided as collateral. Because these debts are secured, the risk is lower for the lender, and they usually offer the borrower with lower interest rates.

Unsecured debt does not require the borrower to provide collateral. Because there is no security for the loan, the interest rate is generally higher and calculated according to factors such as:

  • Credit history
  • Total monthly income
  • Length of employment
  • Total debt owing by the borrower
  • Availability of credit

Know Your Financial Status

Before applying for a personal loan, it essential to make sure of your financial status. If you are up to date with the details of your financial situation, it expedites the loan negotiation process. 

It also gives you a more structured indication of what loan amount you can repay comfortably. It is best to calculate your total debt, monthly expenses, and annual income when approaching a lender.

Know Your Credit Score

Lenders place great importance on a borrower’s credit score when negotiating a personal loan. A credit score is the rating given to consumers that reflects their creditworthiness to potential lenders.

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A wise starting point is to find out exactly what your credit report contains before applying for a loan. Most lenders rely on the FICO score system, which is an acronym for Fair Isaac Corporation, who created the credit score model most commonly used today.

The FICO score system ranges from 300 to 850 when institutions consider granting an individual a loan. According to FICO, the ratings are as follows.

  • Fair credit rating 580 to 669
  • Poor Credit rating 300 to 579

Not only the borrowers with bad credit FICO scores are at a disadvantage when applying for loans. Borrowers with a “thin credit file” contain almost no credit history also pose a potential risk to lenders.

What Does Interest Rate Mean?

Interest rates are the percentage charged by the lender for the use of the loan amount. When a borrower repays a personal loan, he/she will pay back the principal amount and the percentage charged by the lender for the use of the loan amount.

How Will a Personal Loan Affect My Credit Score?

It is essential to enquire if your lender reports to a credit bureau regarding your payment history on the loan amount. If you take out a loan and repay it diligently and on time, your credit score will improve. If you default or fail to make regular payments, your credit score will take a knock.

If you are taking out a personal loan to consolidate your debt, here’s what you should know. Your credit utilization will become lower, and your credit score will improve accordingly. When calculating your credit score, credit bureaus rely heavily on a borrower’s credit utilization ratio. 

This ratio, in essence, is how much you owe, divided by your credit limit, and expressed as a percentage. This credit utilization ratio accounts for 30 percent of your credit score in the FICO model, so one should not underestimate the ratio’s importance. 

How Do I Calculate the Right Amount To Borrow?

The amount that you may borrow is decided upon by your lender, and it relies heavily on your creditworthiness, as expressed by your credit rating. It is essential to know your financial status and be sure that you do not overextend yourself and take a loan amount that you will struggle to repay (https://www.self.inc/blog/is-a-personal-loan-right-for-me).

Borrowers should aim to spend no more than 35% to 43% of their income on debt. Many lenders will be reluctant to provide loans to borrowers whose debt to income ratios are higher than 43%. So if you are taking out a personal loan, you should bear this in mind.

How Long Will I Have to Repay My Personal Loan?

Loan terms refer to the length over which you intend to repay your principal loan amount. You may negotiate these terms with the lender and decide between short-term or long-term repayments according to your preference. 

Generally, the longer the terms you choose as a borrower, the higher your interest will be. So it is wise to shorten your terms and pay back the amount over the shortest terms that are comfortable for you to repay.

So, Now You Know

When taking out a personal loan, make sure to know your financial status before committing to a loan that you may struggle to repay. If you have a bad credit score and seek a personal loan, there are options outside of the traditional banking sphere. 

Online lenders have less rigid requirements and consider other factors beyond your credit score, such as employment and income. Make sure that your lender reports to the credit bureaus and make timely repayments, and you will have a chance to improve your credit score.

Once your credit score improves, you will have access to better interest rates, should you require a loan in the future.

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