Credit comes in many forms, including credit cards, mortgages, automobile loans, purchase financing over time and personal loans. Each type of credit serves a certain purpose for a goal you may have. Whether it’s to buy a house or car, or to allow you to break up a big expense into more manageable monthly payments. There are things you need to know before you apply.
A personal loan is a form of credit that can help you make a big purchase or consolidate high-interest debts. Because personal loans typically have lower interest rates than credit cards, they can be used to consolidate multiple credit card debts. You consolidate into a single, lower-cost monthly payment.
Credit can be a powerful financial tool, but taking out any type of loan is a serious responsibility. Before you decide to apply for a personal loan, it’s important to carefully consider all angles. Namely, the advantages and disadvantages that can affect your unique credit picture.
When you apply for a personal loan, you ask to borrow a specific amount of money from a lending institution like a bank or credit union. While funds from a mortgage must be used to pay for a house and you’d get an auto loan to finance a car purchase, a personal loan can be used for a variety of purposes. You may seek a personal loan to help pay education or medical expenses. Or to purchase a major household item such as a new furnace or appliance, or to consolidate debt.
Repaying a personal loan is different from repaying credit card debt. With a personal loan, you pay fixed-amount instalments over a set period of time. You do this until the debt is completely repaid.
Before you apply for a personal loan, you should know some common loan terms, including:
Whenever you ask a lender for any kind of credit, you’ll have to go through the application process. However, before you submit a personal loan application think of this. It’s important to review your credit report and your credit score. Thus you’ll understand what lenders might see when they pull your credit report and scores. Remember, checking your own credit report never affects your credit scores. Hence you can check as often as you need.
Once you’ve reviewed your credit and taken any necessary steps based on what you see, you can apply for a personal loan through any financial institution such as a bank, credit union or online lender. Every lender you apply to will check your credit report and scores.
Lenders will usually consider your credit scores when reviewing your application, and a higher score generally qualifies you for better interest rates and loan terms on any loans you seek. The lender will also likely look at your debt-to-income ratio (DTI), a number that compares the total amount you owe every month with the total amount you earn. To find your DTI, tally up your recurring monthly debt (including credit cards, mortgage, auto loan, student loan, etc.), and divide by your total gross monthly income (what you earn before taxes, withholdings and expenses). You’ll get a decimal result that you convert into a percentage to arrive at your DTI. Lenders like to see DTIs under 36%, but many may provide loans to borrowers with higher ratios.
When you apply for credit and a lender reviews your credit report, a hard inquiry is noted on your report. Hard inquiries remain on credit reports for two years, and their impact diminishes over time. However, in the short term, too many hard inquiries on your report can have a negative effect on your credit score.
If you’ll be comparison shopping by applying to more than one lender, be sure to do so in a short time frame to minimize the impact of hard inquiries. Generally, credit scoring models will count multiple hard inquiries for the same type of credit product as a single event as long as they occur in a short window of a few weeks. Don’t stretch your comparison shopping and applications over a period of months.
Another option is to ask if a lender can pre-screen or preapprove you for a loan offer. Preapproval often counts as a soft inquiry, which doesn’t affect credit scoring.
Like any other type of credit, a personal loan has advantages and disadvantages, depending on your specific financial situation. Whether a loan is good for you will largely depend on how wisely you’re managing your borrowing over time.
On the plus side, a personal loan can help you make a big purchase. Breaking a large expense into smaller payments over time can help make that cost more manageable when you have stable income. Personal loans typically have interest rates that are lower than what you would pay for a credit card purchase. A personal loan can also be a good way to consolidate multiple high-interest credit card debts into a single, lower-interest payment.
When you take out a personal loan and make on-time payments, you’re helping to build a positive credit history for yourself, which contributes positively to many credit scoring calculations. Your responsible use of credit can positively impact many factors that credit scoring considers, including payment history, credit utilization ratio, and mix of credit types.
However, if you pay late or miss a payment altogether, that can negatively affect your credit. Late or missed payments can lower credit scores, and a lower credit score can limit your ability to get credit at better rates.
If you fall far behind on making loan payments, your personal loan may go into collections or be charged off — and both negative events appear on your credit reports and can also lower your credit scores. Ultimately, if a personal loan makes it harder for you to pay all your bills on time, you may want to consider other options. While not ideal, bankruptcy might be something to look into, but know it can appear on your credit report and negatively affect your credit for seven to ten years.
It’s important to manage any type of credit you use wisely, including a personal loan. Personal loans can be helpful when managed well, but taking on debt should never be something you do lightly – or without looking carefully at your overall financial picture before you pull the trigger.
Before you make any kind of important credit decision, it’s best to check your credit report so you understand your current credit standing. Plus, reviewing your report can help you better understand how your decision may affect your credit in the future.