By Bryan Borzykowski
If you’re thinking about purchasing a big-ticket item or need to consolidate outstanding debts, one option to consider is a personal loan.
A personal loan is a customized financial tool that can provide much-needed cash, sometimes in as little as a week. Borrowers can choose a repayment term with fixed monthly payments that suits their budget. Want to pay the money back within a couple of years? That’s possible. Want to spread out your repayment plan over five years? That’s a possibility too.
“A personal loan is built to meet the specific needs of the borrower, considering the amount of money needed and how it will be used, the timeframe in which the borrower wants to pay the loan back, and the monthly payment amount that meets their budget needs,” said Dan Matysik, vice president at Discover Personal Loans.
There’s no one-size-fits-all approach to personal loans, so borrowers should think carefully about what they need, said Gerri Detweiler, a credit expert and author of Reduce Debt, Reduce Stress.
Consider Monthly Payments
Many repayment periods are between three and six years, said Detweiler. Determining the length of the personal loan that works within your financial plans may come down to how much you can afford to pay back each month. Naturally, a shorter time period would result in higher monthly payments but could save you on interest compared to a longer repayment term.
Alternatively, a longer amortization period could mean lower payments, but you may ultimately pay more interest through the life of the loan.
Detweiler suggests creating a budget to track your spending. Then, fit the loan payment into the budget. If you can afford the higher payments, you may want to request the shorter term. If your budget is tight, or you can’t find places to cut back, then the longer repayment period may be more appropriate.
“You have to understand that it’s part of your budget,” said Detweiler.
Some companies offer online tools to help you determine the personal loan that would fit your financial situation. Discover Personal Loans, for instance, has a Personal Loan Calculator, which helps prospective customers estimate how different loan lengths impact monthly payment amounts.
“It’s important for consumers who apply for a personal loan to know their options,” said Matysik.
Understanding Interest Rates
Before taking out a personal loan, you’ll need to understand how much that loan will cost you over time.
“It’s easy to focus on the monthly payments and overlook the fact that by the time you pay off this loan, you’ll have paid back more than you originally borrowed,” said Detweiler. So if you’re using a personal loan for a major purchase, for instance, consider if borrowing to make the purchase is going to help you meet your goals.
Say you need a new piece of furniture and want to finance the purchase using a store credit card. While rates on in-store loans or company credit cards vary, rates can run between 20 percent and 30 percent, making the total cost of the item a lot more expensive than you might realize.
“When you figure out what the furniture will cost you over several years, you have to think, `Would I buy that furniture at that price?'” said Detweiler. “Really think about whether it makes sense to pay for it that way.”
Personal loans can come with lower interest rates than store loans, but the longer the loan, the more interest payments you’ll make.
If you want to pay less interest, then you may want to take out a shorter-term loan and pay the money back more quickly. If the amount of your total monthly payment matters more and you’d like it to be lower – longer amortizations result in lower monthly payments – then paying the loan back over a longer period could make more sense.
Fortunately, you can find out what your rate will be, and how it contributes to your total payments, before applying for a loan, said Matysik. Discover Personal Loans allows potential customers to see the rate they’ll receive without actually applying for the loan, with no impact to their credit score.
Avoid Extra Fees
It’s also important to consider any additional fees the lender may charge. In some cases, a financial institution may charge an origination fee – a fee for processing a new loan. That can be costly.
“Consumers certainly don’t want any surprises down the road when taking out a loan, so they should be careful to avoid upfront fees or prepayment penalties,” said Matysik. There are some lenders, like Discover Personal Loans, that don’t charge any processing fees or prepayment penalties.
If you think that money may get tight at some point during the repayment period, you might accept the lower monthly payment and pay a little extra each month.
Ultimately, only you can determine what type of loan is right for you. But the less you pay in fees and the deeper your understanding of your personal financial situation, the better off you may be going forward.
Bryan Borzykowski’s writing focuses on investing, personal finance, small business and technology. His work has appeared in the New York Times, CNBC, CNNMoney and BBC Capital, among other publications. He’s also written three personal finance books. Follow Bryan on twitter @bborzyko.
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