Personal loans can be used for almost any purpose, which means they are one of the most flexible ways to borrow money—without those high credit card interest rates.
Borrowed from a bank, credit union, or online lender, unsecured personal loans can be used for many personal things, whether it’s installing a new energy-saving heating system in your home, or consolidating high-interest consumer debt, such as a credit card balance.
If possible, it’s often better to save for a big expense, even if it takes a few months or even years. However, if you find yourself in a situation where that’s not possible, a personal loan may be a better option than charging the expense to a credit card.
So, what’s to stop people from borrowing money for a yacht and sailing away to the Mediterranean, never to return? Simple: You will need to meet the credit, income, and other financial criteria of the lender you have chosen to give you the money. These criteria can vary from lender to lender depending upon each lender’s risk tolerance and other factors.
Meeting the chosen lender’s criteria assures them you can repay the loan. From a lender’s perspective, unsecured personal loans may be riskier than other types of loans because they don’t require any collateral to secure the loan. That’s where lending requirements come into play.
For example, most lenders have specific credit score or income requirements, and others may ask for an origination fee.
Your lender’s perceived importance of any given category may not only determine whether you qualify for a personal loan, but at what rate and term.
All lenders are different, which means there is no universal list of qualification requirements for an unsecured personal loan. Instead, here’s a list of common things lenders may look for in a borrower to help you be more prepared as you begin to apply.
One of the key metrics lenders look at when qualifying a potential borrower for any loan is credit score. Generally, the higher the credit score, the more likely lenders are to give out a loan to a borrower with a more favorable interest rate. All else equal, you’ll want the best possible rate on your loan; it can make a big difference in the total cost of your loan over time.
You may want to ask whether a lender plans on doing a “soft” credit check during the prequalification process (this is where you check your rates). Many lenders do a soft credit check at first—that is, a credit check that does not affect your credit score—in order to see if you’re a good candidate for a personal loan.
As the process moves forward, and an applicant actually applies for a personal loan, lenders will usually do a hard credit check (that is, a deep dive into your credit history). Again, a soft credit check doesn’t affect your score, but a hard credit check may knock five to 10 points off your credit score, and could impact your score for a few months.
Some lenders take a harder line when it comes to unsecured loans—if you have a lower score or a shorter credit history, for example, it may be harder to find a loan program where you fit the eligibility requirements.
Some lenders, however, may review your credit history as well as your credit score, plus other financial factors like your income, to create a more holistic view of your financial situation.
Some lenders—not all—have an origination fee, which is a fee that’s charged to cover the cost of processing the loan. This origination fee is often a percentage of the total loan amount, typically around 1%-8% of the total amount being borrowed.
Since this can be a considerable sum of money, depending on the loan size, you may want to keep this in mind. Note that you can typically include this cost into your loan’s total, or pay for it with the loan itself.
There are two types of personal loans, collateralized and uncollateralized. Generally, collateral is something of value that is used as security for repayment of a loan. In the event of default, the bank or lender may be able to seize the property from the borrower.
When a loan requires collateral, it’s generally referred to as a “secured loan.” When it does not, it is called an “unsecured loan.”
The level of security is from the vantage point of the bank or lender; an unsecured loan may be less secure to them, given it’s “secured” simply by a person’s personal financial picture and not a tangible asset like a car or a house, and therefore they take that into consideration when making that loan.
A bank or lender’s parameters for secured and unsecured loans are likely different, so you may consider asking for details about what they offer and determine whether you might qualify.
Typically, when people talk about personal loans, they’re referring to unsecured personal loans. Because these loans aren’t backed by collateral they may offer higher interest rates or be harder to qualify for than secured personal loans.
But some lenders and banks may require collateral for personal loans. Anything from cars to property can be used as collateral, and can be seized in the event that you fail to make your loan payments. This is the tradeoff that you may want to consider: If you put your property on the line, you could lose it, but taking that risk may qualify you for a lower interest rate. Here’s why:
Collateral gives your lender additional assurance that they’ll be paid back. On the flip side, offering up collateral can come with hidden costs. For example, some lenders may require you to have additional insurance in the event the collateralized property is damaged.
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Proof of Income and Employment
Most lenders will want to be sure that you are gainfully employed and have sufficient income to repay the loan.
Proof of income and employment can be required by many lenders to verify the income stream that will be used to repay the loan. This is one way they can ascertain the likelihood that you’ll pay the loan back—and that can affect things like the interest rate or loan term you may be offered.
Like most personal loan requirements, “proof of income” can mean different things for different lenders. Some lenders may require a signed letter from your employer, while some will need pay stubs or W2s. If you are self-employed, this might mean you’ll need to submit a copy of your tax returns or provide bank deposit information
Debt-to-Income Ratiodebt-to-income ratio (DTI). DTI is a ratio that compares your gross monthly income to the monthly payments you make towards debt.
Generally, the lower your DTI the more desirable you may be as a borrower for any lender. For example, someone earning $120,000 per year might seem like they’re doing great. That’s $10,000 in gross income per month.
But let’s say they’re actually having a tough time making ends meet because they’re paying $6,000 per month toward their credit card and student loan debt. Their DTI is 60%, which is considered high—which might make them less desirable to lenders.
Conversely, someone with a lower income, say $60,000 per year, might get better terms on their personal loan offer if they are only paying $500 a month toward student loans. In this scenario, they are earning $5,000 per month and paying $500 per month toward debt, which makes their DTI 10%.
Applying For a Personal Loan
Maintaining a Stable Income
Although the exact formula may vary, lenders typically prefer a borrower with a stable income. If you plan to apply for a personal loan, it may not be the time to change careers.
If there are other ways to boost your income in the meantime, this may help as well. Whether that means asking for a raise or picking up part-time work, increasing your cash inflow may make you a more desirable borrower in the eyes of a lender, although not all income is considered eligible to use in loan qualifying.
Getting a Co-Signer or Co-Borrower
In brief: A co-signer is someone who agrees to pay the loan if you default. A co-borrower is someone who may reside with you and takes the loan out with you—their name is on the loan, and you both have an obligation to repay it.
Either may improve your chances of qualifying for a personal loan, as lenders view both as an extra layer of repayment security.
Before deciding to bring someone else into the equation, you may want to check with the lender if a co-signer or co-borrower is allowed and then carefully consider the drawbacks as well. For instance, a co-signer might see a decrease in their credit score if you fail to make a payment. And a co-borrower would have to pay the loan themselves if you default. There are risks for the primary borrower, too: defaulting on the loan may negatively impact their credit score, and may also ultimately result in a lawsuit for collections or a garnishment of wages.
Improving Your Credit Score
If your credit score is less than ideal, you may want to take steps to improve it. A potential first step would be to eliminate any late payments or delinquencies reported in error. You might check your credit history for errors, such as fraud, misreporting, or a card accidentally opened in your name. You might then ask the credit reporting bureaus to remove any errors that you find.
Sometimes, credit score improvements take time. Do your best to pay every bill on time. It may also help to pay off your credit cards, in full, each month.
Another strategy is to reduce how much debt you’re carrying relative to your credit limits. You might begin by paying down your balance as much as you can.
Creating a game plan for paying down your debt is a great next step to take. Three well-known methods for paying down debt are the avalanche, the snowball, and the snowflake.
With the debt avalanche, you’d pay off the debts with the highest interest rates first, and then go from there (paying at least the minimum balances on everything else, of course). The goal is to save the most money on interest. The debt snowball is a bit different, and is based on motivation and psychological momentum.
With this method, you’d work towards paying off your smallest debt first, again while still making payments on all your other debts, hopefully creating a feeling of success that will catalyze paying off larger and larger debts, until all your debts are paid off.
The debt snowflake operates differently from the other two, since it can be applied to either. Using whatever small amounts of cash or windfall on hand at any given time, you’d make extra payments towards your debt wherever and whenever possible. And of course you’ll want to make sure you’re still making at least the minimum payments on all your debts each month.
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