When you have an unexpected expense or need to make a purchase that exceeds your savings, you may need to take on debt to get by. If you need flexibility, you might opt for a form of revolving credit, such as a credit card or line of credit.
But if you need a specific amount of money on a one-time basis, it could make more sense to take out a personal loan—an instalment loan that’s repaid over a set term, or time period. You repay monthly until the loan is paid in full.
Some big banks don’t offer personal loans and those that do tend to have stringent credit score criteria and turn away customers without a credit score of at least 670. That doesn’t mean personal loans are hard to find, though; many credit unions and an increasing number of online-only lenders offer multiple types of personal loans.
Common Uses for a Personal Loan
While it’s always preferable to use savings for major purchases and avoid taking on debt, sometimes that just isn’t an option. Personal loans shouldn’t be used frivolously, especially if you could pay for the expense by waiting and saving. If financing is a must, however, personal loans are often a worthwhile option since they often come with lower interest rates and higher limits than credit cards.
Some loans must be used for specific purchases, like an auto loan to buy a car or a mortgage to buy a house. But personal loans can be used for any number of purposes, such as:
- Consolidation of higher-interest debt, like credit cards or student loans
- Medical procedures that aren’t covered by insurance, such as fertility treatments or cosmetic surgery
- Vacations or weddings that you’d rather not wait to save up for
- Home improvements or repairs
- Large purchases such as a home appliance
Types of Personal Loans
The most common type of personal loan is an unsecured, fixed-rate loan, but some lenders offer other options that you should be aware of as you shop around.
Unsecured Personal Loans
Most personal loans are unsecured, meaning no collateral is required to guarantee a loan. An auto loan uses your car as collateral, so if you can’t make your payments, the lender can repossess your car.
On the other hand, an unsecured personal loan doesn’t have a physical asset backing it, so if you struggle to make payments, there’s no property the lender can take away from you. Your solid credit history, and possibly that of a co-signer, is what backs the loan. If you’re in the market for an unsecured personal loan, you’ll typically need a good credit score—670 to 739—or better, according to credit bureau Experian.
There are still negative consequences, though, if you can’t repay your unsecured personal loan. If you make late payments, it can hurt your credit, and if you fail to make payments, your personal loan account could go into collections and wreck your credit score in the process.
Because unsecured loans require no collateral, they’re inherently riskier to the lender, so you can typically only qualify for an unsecured personal loan if your credit is in solid shape.
Secured Personal Loans
If your credit could use some improvement, you may still be able to qualify for a personal loan, but the lender might require that it be in the form of a secured loan. This means you will have to provide an asset to guarantee the loan, such as a vehicle, savings account or certificate of deposit.
The good news is that the interest rate on secured personal loans is usually lower than unsecured loans. That’s because there’s less risk for the lender since they can take your collateral if you can’t make your payments.
Fixed-Rate Personal Loans
Personal loans are usually fixed-rate, meaning the interest rate remains the same for the life of the loan, as does your monthly payment. The benefit is you’ll know exactly how much your instalment will be each month, making it easier to fit in your budget. You’ll also be able to know in advance how much interest you’ll pay over the life of the loan. A personal loan calculator can help you estimate your monthly payments before you apply.
Adjustable-Rate Personal Loans
While less common than fixed-rate personal loans, some lenders offer adjustable-rate personal loans. Rather than having the same interest rate forever, your interest rate is subject to change over time.
The appeal of adjustable-rate loans also called variable- or float-rate loans is that the interest rate typically starts off quite low. After a certain time frame, the interest rate may increase depending on market conditions, so the monthly payment can go up or down.
While there are usually caps in place to prevent you from paying more than a certain amount of interest, you do run the risk of getting stuck with a higher rate and unpredictable monthly payments. For that reason, taking out an adjustable-rate personal loan usually is only recommended if you can pay off the loan quickly.
Personal Loan Alternatives
Personal loans are ideal for certain expenses, but you may want to consider some other options before you decide on the best type of financing for you:
- Savings. This isn’t always possible if you need a loan to pay for an urgent expense, such as an unexpected home repair or emergency medical procedure. But if it’s something that can wait, it’s smarter to save up and pay cash. This helps you avoid paying interest, and it keeps you from taking on debt, which can affect your credit and overall finances negatively.
- Credit cards. While personal loans are ideal for single large purchases, credit cards are often best for smaller purchases over time. This is in part because their interest rates are typically higher than personal loans, and you usually can’t borrow as much with a credit card. They’re a form of revolving credit, meaning you’re granted a credit line that you can use as needed. You only pay interest on what you use, and once you repay your debt, you can re-borrow up to the credit limit. Also, rather than repaying in fixed monthly payments, credit cards only require a monthly minimum payment. This offers more flexibility than personal loans, but since there’s no set repayment schedule or term, it’s easier to find yourself stuck in debt.
- Lines of credit. A line of credit is another form of revolving credit, where you have a credit limit and only pay interest on what you borrow. You must repay a monthly minimum based on how much you borrow, similar to a credit card, and you can re-borrow the funds. One option is a personal line of credit, which is similar to an unsecured loan. Another option is a home equity line of credit, which uses your home as collateral. However, lines of credit act more like loans in that you have a reserve of cash to draw from rather than having to put purchases on plastic. When you have a line of credit, you usually access the money by writing a check or having the lender transfer it to your bank account.
- Payday loans. Consumers with poor credit who struggle to qualify for personal loans may turn to payday loans as a form of quick cash, especially since lending standards are minimal and the loan amounts are small. But payday loans are considered a predatory form of lending since the fees are astronomical and add up quickly, according to the Consumer Financial Protection Bureau, leaving many people trapped in debt. Avoid these if at all possible.
If you have a major life expense, there are plenty of types of personal loans and other financing options to choose from. Just make sure to do your research, compare quotes from multiple lenders and be aware of how a loan can impact your credit, both positively and negatively.