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When you’re facing a large, one-time expense and don’t have the cash on hand to pay it, taking out a personal loan could be an attractive option.
How Personal Loans Work
Personal loans are unsecured, meaning that they aren’t backed by collateral. By contrast, a home mortgage is secured by your home, and a car loan is backed by your car. If worse comes to worse and you fail to repay those types of loans, the lender knows it has an asset it can try to seize and sell.
By contrast, your eligibility for a personal loan is likely to be determined by your credit score from one of major credit bureaus, as well as such factors as your employment history, income, and debt-to-income ratio.
Personal loans generally carry a fixed interest rate and require that you pay the lender back in monthly installments over a specific term, such as two to five years. Because no collateral is involved, the interest rates on personal loans tend to be higher than on many other types of borrowing.
The average interest rates on personal loans recently ranged from 10% to 32%. People with excellent credit scores (720-850) were likely to be able to obtain loans with average annual percentage rates of 10% to 12.5%, while those with poor credit scores (300-639) faced average APRs of 28.5% to 32%.
If you’re eligible for a low-rate personal loan, you might also consider using one to pay off other, higher-interest debts, such as credit card balances. But bear in mind that the personal loan will have to be paid off in its entirety by a certain date, while your credit cards do not. The federal Consumer Financial Protection Bureau also cautions against debt consolidation loans that start off with low “teaser rates” that can shoot up after a period of time.
You’ll also want to be sure you know about any additional fees. For example, many lenders charge an origination fee of 1% to 6% of the loan. Others may impose a prepayment fee (otherwise known as an exit fee) if you want to pay your loan off early.
An alternative to a personal loan for paying off credit-card debt is a balance-transfer card. These allow you, usually for a fee of 3% of the balance, to transfer your card balance to a new card with a different bank that offers 0% APR for a specified period.
Where To Get a Personal Loan
The first place to go shopping for a personal loan is your local bank or credit union. If you already have a relationship there, you may have less trouble securing a loan. Credit unions, in particular, are known for their relatively reasonable interest rates.
Your next stop should be competing banks (and another credit union if you belong to more than one), to compare rates.
Online lenders are another possibility, but make sure you’re dealing with a legitimate one, as this field is rife with scam artists whose websites may look perfectly respectable. In fact, they may not be in the loan business at all but simply collecting personal financial information from unwary borrowers that they can use to commit identity theft.
To protect yourself, the Federal Deposit Insurance Corporation suggests checking with your state attorney general’s office or the state or local consumer affairs department to see if they have any complaints about a particular lender. The Better Business Bureau also has ratings on many lenders.
Loan Alternatives With Drawbacks
You may have other sources of emergency cash besides a personal loan, though not all are ideal. Here are some to be wary of, and consider only as a last resort:
Credit-card cash advance. Taking a cash advance on a credit card is a fast way to pay off a big, unexpected bill. But it’s also a very expensive one. You’ll typically pay $ 9 or 4% of the total as an upfront fee. The APR on the loan is 24%, which is far higher than on purchases. And, unlike with purchases, there’s no grace period; you’re charged interest from the time you receive your money.
A home equity loan or line of credit. If you have enough equity built up in your home, you may be able to borrow against it. A home-equity loan typically provides you with a lump sum that you agree to pay back on a set timetable. A home equity line of credit makes a sum of money available to you that you can borrow from as needed. Home equity loans and credit lines may have more attractive interest rates and terms than personal loans, although they may also take longer to obtain. Remember, too, that you’ll be risking your home if you find yourself unable to repay.
Payday loans. This form of financing, in which you borrow against your paycheck, may be the worst option of all. Payday loans charge exorbitant fees and interest rates, with APRs regularly topping 300% to 400%. They also have short payback terms of only a few weeks, making it all too easy to fall into a debt cycle. In fact, payday loan borrowers are more likely to declare bankruptcy. Because of this, some states have moved to ban or significantly limit payday loans.
Finally, one way to avoid needing a personal loan in the first place is to establish an emergency fund that you can use for those big, unanticipated bills. Many financial planners suggest saving at least three to six months of living expenses in an account that you can get cash from quickly, such as a bank savings account or a money market mutual fund.
The article How to Get the Most Out of a Personal Loan originally appeared on ValuePenguin
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.