By Ashley Sweren,
LendingTree, January 8, 2018
Personal loans can be a useful tool when cash is tight, helping to bridge gaps between your savings and your spending needs. They can also help you build credit and pay down debts faster if you’re able to qualify for a loan with a lower interest rate. Before you begin applying for personal loans, make sure you know how to get the best possible rate and how to improve your chances of getting approved for a loan.
Personal loans and their uses
The most common use for personal loans is debt consolidation, says Josh Tonderys, president of personal loan company Best Egg. “More often than not, it is a combination of debt consolidation and something else,” he told LendingTree.
But there are typically no formal restrictions on how money from a personal loan can be spent. Here are other ways to use personal loans:
- Financing large purchases like home appliances
- Funding home improvement projects and repairs
- Consolidating medical debt
- Paying for special events or occasions, such as weddings or vacations
- Consolidating existing debts for a lower interest rate and one monthly payment
- Gaining access to cash
- Building or improving personal credit
A personal loan allows individuals to borrow money from a bank or other lending institution with no collateral. As these loans are unsecured, they are also commonly referred to as “signature loans,” since they are only guaranteed by your signature (and your credit, which we’ll get to later). Though there is less risk for the borrower, it increases risk for the lender, which is why you might find higher interest rates on personal loans than on other secured types of financing.
If you have excellent credit and good income, it’s possible to find personal loans that carry an interest rate lower than credit cards, which is why they are attractive to consumers and often used to consolidate and pay off existing debts. However, unlike credit cards, some personal loans involve origination fees (ranging from 1 to 6 percent of the loan amount) or other fees for late or insufficient payment, according to Tonderys. Personal loans typically range from one to seven years, depending on your needs, Tonderys said. Generally, rates are better and you’ll pay less interest overall with a shorter term length.
If you already have an existing relationship with a financial institution, that is a good place to start when considering a personal loan, as representatives can give you information about your personal loan approval odds and how a personal loan can fit into the big picture of your finances. If you don’t have a preferred bank or lender, you can start by visiting local banks and credit unions for information on personal loans. There are also services like LendingTree that allow you to shop for loans and compare options conveniently online.
If you don’t meet traditional loan approval criteria, peer-to-peer lenders and other alternative lenders can be an option, though they may charge higher interest rates.
How personal loan approval is determined
Different lenders have different ways of establishing personal loan approval and for which rates and terms approved individuals qualify. Though methods vary, there are some underlying commonalities.
“Basically, we look at how a person manages their finances overall,” said Deborah Crouch, vice president of credit administration at Tech CU, a credit union serving more than 90,000 members throughout the San Francisco Bay Area. “Are the bills paid on time, is there sufficient income for repayment, do they have capacity [to take on debt]?”
They can get this information by looking at a borrower’s income and total debt obligations, and comparing them to see how much wiggle room they have in their budget for more debt.
Another important barometer employed to determine personal loan approval is your credit score.
Credit scoring is a system used by creditors to measure your creditworthiness. It helps lenders measure the risk level associated with lending you money. Things like your payment history, the variety of and average age of your credit accounts, and your outstanding debt inform your credit score. Credit scoring agencies apply statistics to arrive at a numerical score used to predict whether or not you are likely to repay your debts.
The FICO score, which is the most widely-used score today, ranges from 300 to 850, with 850 being a perfect score. The higher your score, the more likely you’ll be approved for a personal loan, and the better the rates and terms you’ll be offered.
Improving your credit score can increase your chances of getting approved for a personal loan as well as broaden your access to more competitive rates and terms. Working on your credit score takes time and patience, but it can be done by making commitments like:
- Paying your bills on time to avoid collections and bankruptcy
- Paying down outstanding balances
- Ending bad habits like maxing out (or coming close to maxing out) credit cards
- Stopping the impulse to open new accounts unnecessarily (e.g., store-specific cards that earn discounts and rewards)
In some cases, a low credit score can result from a lack of credit history. If this is the case for you, open a credit account and use it responsibly. Pay off balances immediately just to build credit in your name.
Crouch echoed this for improving your chances of personal loan approval prior to applying.
“Make certain you are not overextended, keep your credit card balances low relative to your limits, and make certain you have no delinquency,” she said.
Tonderys added this advice: “Consumers can spend some time better understanding the payment amount they can afford and request a loan amount in line with that number. Requesting more than you can usually indicates a higher-risk applicant and is less likely to result in an approval.”
What your credit score means
Many services exist that allow you to review your credit score and report. LendingTree offers consumers a free look at their credit score. Knowing where you stand can help you gauge the likelihood of personal loan approval and can give you insights on how lenders view you. However, it’s not the only factor. Lenders will still consider your income and debt-to-income ratio.
Also don’t be surprised if you get a higher rate than what is advertised on a lender’s site.
“For personal loans, you will find that the advertised rate is typically the best available – meant for the top bracket of credit score bearers,” said Theresa Williams-Barrett, vice president of consumer lending and loan administration at Affinity Federal Credit Union.
“Consumers must read the fine print and disclosures to determine the requirements for the advertised rate.”
The following are insights on lenders’ perceptions of individuals scoring within certain credit score ranges.
These individuals are extremely responsible with their finances and are very likely to pay back their loan on time. They should have no problem getting approved for a personal loan and will be able to shop the best rates and terms.
“Every lender is different, but generally, mid- to higher-scoring individuals have an advantage over someone with a lower score,” Crouch said. “This is typically because lower scores mean that a person may not be handling their finances well and this is concerning to a lender.”
People in this range have good credit. They pose little risk to lenders and will likely be approved for a loan with competitive rates and terms.
Individuals in this range should not have trouble getting approved for a loan, though they may not be offered the best rates and terms. Williams-Barrett explained: “Typically, consumers in this range could have some issues — a severe delinquency or two, or some very high balances and high utilization. They are typically candidates for unsecured credit, but are often reviewed based on other criteria and compensating factors.”
Borrowers in this range are considered “subprime.” Though they may be approved for a loan, it will be with less-than-favorable conditions. “Consumers in this category have a very hard time paying credit, or have very low available credit,” said Williams-Barrett. “They might be using credit to manage day-to-day costs of living, like utilities and groceries, so it is very likely they could have trouble paying if their financial situation changes even slightly.”
People with these scores are considered high risk with very poor credit. It is unlikely they will be approved for a personal loan from a traditional bank. If they are, the loan will probably entail added fees, require a co-signer, or require some kind of collateral. Sometimes, it’s better for a borrower to improve his or her credit and re-apply later.
“Those at the lowest end [on the credit score range] would most likely not be eligible for credit,” Williams-Barrett said.
Lenders with alternative underwriting methods
If your credit score is in the lower ranges, there is still a chance you can obtain a personal loan.
“I sometimes see cases where an individual has excessive revolving debt, but they pay their bills in a timely manner and [show that they can repay the debt],” Crouch said. In other words, if you have a high enough income to show you can manage your debt load, you’ve got a better shot at getting approved despite high debt balances.
There are some subprime lenders that will extend unsecured loans to those with lower credit scores, though they may charge steep fees and high interest rates. Before committing to any loan, borrowers should ensure the repayment schedule is not too aggressive and won’t endanger their financial health.
“I would just caution a person to be smart about the decision they make,” Crouch said. “Do your research.”
There are other lenders that use alternative underwriting methods that allow those with a less desirable credit history to obtain personal loans.
For example, SoFi rates applicants based on education, career experience, financial history, and monthly income versus expenses. Upstart also uses non-traditional variables, such as education and job history to determine creditworthiness. And Earnest tailors to recent college graduates by ranking them based on their future potential for creditworthiness rather than focusing exclusively on their past financial history. This includes examining things like savings, cash flow, and debt-to-income ratio.
Alternative forms of financing
If an unsecured personal loan is simply not in the cards for you, there are other types of financing for which you may qualify.
Secured personal loan
These are personal loans that allow you to put a valuable item up as collateral. Since this eliminates a bit of risk for the lender, you may be able to get a loan with slightly more attractive rates and terms than with an unsecured alternative. However, borrowers need to understand that if you default on a secured loan, you can lose whatever collateral you put up (often a vehicle or home) as well as further damage your financial standing. Examples of secured loans are a title loan or a home equity loan.
Cosigned personal loan
If you have someone who is willing to cosign your loan, you may be able to secure a personal loan with bad credit. With a cosigner, that person assumes equal responsibility for the repayment of your loan. So, if you default, they need to pay the loan back or incur negative repercussions on their credit. Often, young first-time borrowers will have a parent co-sign their loan. Ultimately, if managed sensibly, this can help new borrowers build their credit score.
Secured credit cards
Though it may be difficult to open a new credit card with a poor credit history, some cards offer a secured card option that uses money deposited into your banking accounts as collateral. This decreases risk for the credit card company, so it can offer options to low-credit individuals. If you use the card responsibly, it can ultimately help you improve your credit rating.
With peer-to-peer (P2P) loans, you borrow not from an organization like a bank, but from individuals who crowdfund loans for profit online. Some P2P platforms will give loans to those who don’t qualify for traditional personal loans. However, the interest rate and terms will reflect the risk level.
Home equity line of credit
If you have significant equity in your home, you may be able to borrow against it with a home equity line of credit (HELOC). Since your home functions as collateral in a HELOC, rates are very low. HELOCs also offer tax benefits and flexible repayment schedules. Just be sure taking equity out of your home does not conflict with your long-term financial plans.
Some words of caution if you’re shopping for a personal loan with poor credit:
There are additional financing alternatives such as payday loans, title loans, and loans from other organizations that prey on individuals with bad credit by charging exorbitant fees. Be wary of any offer that seems to good to be true.
Often, these lenders do not have your long-term interests in mind and are hoping that you default.
“Doing the research is important to protect yourself,” Crouch added. “Look at consumer reviews, talk with a financial advisor, ask your local credit union, or ask a friend or relative for a recommendation.”
Tonderys recommended searching online to see how customers have commented on businesses in the past. Check out sites like Trustpilot, Best Company, LendingTree, or the Better Business Bureau. Even a quick Google search with the lender’s name is better than nothing.
Before committing to any personal loan, ensure that doing so adheres with your big-picture financial plans. Make sure the proceeds will be used for something that will benefit you long term (e.g., replacing a refrigerator versus overspending on a lavish vacation).
And confirm that the lender is reputable and the loan is something you can realistically manage from month to month. When these criteria are met, a personal loan can be a powerful tool to help you get what you need while meeting your financial goals.