Guide to personal loans: 7 questions to ask

Not sure where to start with a personal loan? This guide breaks down key questions to help first-time borrowers make confident decisions.

Many loans seem self-explanatory based on their titles. It’s clear, for instance, that an auto loan will help you get a car. Or that a student loan goes to fund education. Mortgages finance houses, business loans bankroll business ventures, and so on.

By comparison, the term “personal loan” doesn’t reveal much about how this type of financing can help reach your goals. In fact, you can put the money from a personal loan toward just about anything you wish. And, if the lender is satisfied with your income information, you can often receive the loan funds in your account within a week or less.

If you're looking to explore this option, first ask yourself these questions:

1. How do I know if a personal loan is right for me?

Applying for a personal loan makes the most sense in certain cases. For instance:

• It may be the least expensive form of credit available to you:  Make sure you explore every available alternative before you start applying for any kind of loan. Would a 0 percent APR credit card or balance transfer, for example, offer a more sustainable or cheaper choice? (Of course, you'd need to pay off the balance by the time the 0 percent rate expires.)
• You plan to do something that could give you a return on your investment: Home renovation is a popular option for this type of loan. Because home equity lines of credit (HELOCs) and home equity loans can also be good options for funding a home remodel, make sure you talk with your banker to find the product that works best for your situation.
• You feel confident making the monthly payments: Explore ways you can bring in extra income, cut unnecessary expenses, or both, to help you meet your repayment obligations. Generally, the higher your credit score, the lower (to a point) your interest rate will be on a personal loan.

2. What are some common types of loans, and how are they different than a personal loan? 

A wide range of loans exist to fit different needs and goals.

Credit cards 
Credit cards are a form of short-term revolving credit, typically used for everyday spending. To avoid high interest rates, pay off your balance each month.

Student loans 
If you need money to pay for education costs, federal student loans have fixed interest rates while private loans may have fixed or variable rates. Before taking out a student loan, remember that grants or scholarships may be an option, too.

Personal loans 
These loans are flexible and can be used for nearly any purpose, like consolidating debt or financing home renovations. Most personal loans are unsecured, meaning they don’t require you to give up an asset like a car or house if you can’t pay the loan. (The house or car are considered collateral.)

Auto Loans 
Auto loans are designed for vehicle purchases and require the car to act as collateral. They generally have terms of 84 months or less.

Mortgages 
Mortgage loans are used to buy a home and may offer fixed or variable rates. Missing payments could result in foreclosure, which means losing the home.

Home equity loans and home equity lines of credit (HELOCs) 
These allow you to borrow money, using the equity in your home. For instance, if your home is worth $400,000 and you still owe $150,000 on your mortgage, you may be able to borrow up to $250,000 using equity.  A home equity loan provides a lump sum, while a HELOC functions like a revolving credit line.

3. How much can I borrow and how do I receive the money? 

If approved for the loan, you receive the principal in one lump sum payout. The amount you can borrow depends on a number of factors, including your credit score. Generally speaking, the principal amount often sits somewhere between $1,000 and $25,000, though some banks offer higher loan amounts for their customers. In considering how much to borrow, make sure you feel comfortable making the monthly payments.

4. How do I receive the money and what will my payments look like?

A personal loan is an installment loan. That means you owe a fixed amount each month until you pay off the entire amount. Most personal loans have a payback period between 12 and 60 months. The term of a loan is the amount of time it takes to pay off the entire amount – assuming you make all your payments on time.

Personal loans may be either short-term (1 to 5 years) or long-term (up to 30 years). Either way, by the time your term is complete, you will need to have paid off the principal (the lump-sum amount you receive). You’ll also need to factor in monthly interest.

Depending on the amount needed for your loan, and your current (or projected) financial standing, you’ll want to consider:

• Am I better off choosing a longer loan term so each monthly payment will be less?
• Or, should I opt for a shorter term so I spend less on interest over the life of the loan?
• Is there a prepayment penalty if I want to pay back my loan before the term is up?

5. What are some of the loan fees and costs involved with personal loans?

Many (though not all) personal loans are unsecured. An unsecured loan doesn’t require the borrower to put up collateral, such as a home or car, to match the value of the amount borrowed.

Unsecured also means if you were to default on the loan, the lender wouldn’t be able to claim your property as they would in the case of a secured loan. To offset this risk lenders will often charge higher interest rates.

In addition to interest, loans often come with additional charges and fees. The Truth in Lending Act requires that interest and fees are disclosed in a clear and uniform manner:

• Amount financed: This is the amount of money the loan provided to you.

• Annual percentage rate (APR): This is the yearly cost of your loan, shown as a percentage. When shopping for loans, you should compare APRs instead of interest rates. APRs include the cost of interest and other finance charges.

• Finance charge: This is the cost of your loan, expressed in dollars. It can include interest, service charges and other loan fees.

• Interest: There are two types of interest rates. Fixed rates stay the same the entire time you’re paying back the loan. Variable rates may change during the loan term, going up, down or both.

• Total payments: The full amount you'll pay over the loan term. This amount includes the principal, interest and fees.

6. Will applying for a personal loan hurt my credit?

When you apply for loans, potential lenders will pull your credit history to help determine whether or not they are willing to loan you money.  In many cases, this type of credit check is considered a hard inquiry, which can cause your score to dip for a few months.

It may not be a big deal if you have strong credit. But if you have concerns about your credit standing, talk to your lender and ask for loan applications that only use a soft inquiry, which doesn't affect your score.

7. Which type of lender should I choose? 

Do some comparison shopping. Rates and fees can vary between lenders so it’s best to dive in and weigh your options before applying.