What Are Personal Loans and How Do They Work?

Apr 22, 2022

3

min read

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oans are like a time machine that helps you to use future cash flows. You borrow the lump sum money from the lender today and pay it back in installments and interest later.

If you are looking for a loan to purchase a home, there is a home loan/ mortgage loan. The loans are borrowed for a specified reason, and there are loans available specifically for that purpose.

However, sometimes we need to borrow loans for general purposes such as emergencies, weddings, or moving out. That's when personal loans are used.

Personal loans are best when taking out loans for general purposes.

What Is A Personal Loan?

Personal loans are unsecured loans borrowed from a financial institution for any purpose. These loans are not borrowed for a specific reason and can be used for many purposes, such as debt consolidation, home improvement, or medical expenses.

Usually, personal loans do not require any collateral to secure the loan. Hence, they are called unsecured or signature loans. Personal loans are approved based on credit score and creditworthiness.

Like other loans, personal loans also offer a certain amount of money at a specific interest rate for a period of time.

For instance, if you need $10,000 for your wedding and have a good credit score. You can borrow a personal loan from any financial institution without keeping any assets as collateral.

How Does A Personal Loan Work?

The person who wants to borrow the personal loan first needs to fill up the application form and submit it to the lender. The lender then runs a credit check to determine your creditworthiness.

Your credit history and credit worthiness play a considerable role in approving or rejecting your application for the loan. Generally, a credit score higher than 640 is required to apply for a personal loan.

The lender will offer you a loan contract if your loan is approved, including the loan amount and interest rates. After you agree on the loan terms, the bank will fund the loan, which can be directly deposited into your bank account, or a check is given to you.

Now, you can use the funds according to your need and pay the loan back, including the interest. However, personal loans exist in various forms, such as secured and unsecured loans.

In a secured personal loan, you must provide collateral, and if you default, the lender takes possession of the asset.

However, if you default on an unsecured loan, which is the most popular type of personal loan, the lender will not be able to seize any of your possessions. However, there is a considerable consequence instead.

If you fail on an unsecured personal loan, the repercussions will severely damage your credit score. In addition, the lender has the right to lodge a lawsuit against you to recover the unpaid amount, interest, and fees.

When To Get a Personal Loan?

Emergency Cash Requirement

You can take out a personal loan if you need money right away to cover bills or emergency expenses. Personal loans are comparatively easy and quicker than other loans. Depending on your lender, you can receive the fund on the same day or within a few days.

A personal loan can cover medical expenses, funeral expenses, and other emergency requirements. It is a perfect substitute for a payday loan.

Payday loans are high-interest, short-term loans that must be repaid when you receive your next paycheck, whereas personal loans are comparatively cheaper.

Debt Consolidation

A personal loan may be used to consolidate debts, particularly credit card debt. It's also one of the most common reasons for taking out a personal loan.

Personal loans offer cheaper interest rates than credit cards, especially if your credit profile is strong. People with good credit profiles can borrow personal loans at interest rates as low as 4%, which is far lower than the double-digit percentages charged by most credit cards.

You may get a personal loan, pay off your credit card balances, and then make a single payment to your new lender at a comparatively cheaper interest rate.

Vehicle Financing

If you want to purchase or lease a vehicle, you can take out personal loans instead of auto loans. Although auto loans offer lower interest rates than personal loans, they are secured loans that require the use of your car as collateral.

A personal loan may be a better alternative if you're concerned about failing payments and having your vehicle seized.

Wedding Expense

Most people take out personal loans to cover their weddings. Weddings are one-time events, and people want to make their weddings grand and memorable.

They also take out loans to finance their honeymoon phase. While it's not a good idea to borrow loans for weddings, the debt for a brief moment will haunt you for a lifetime.

However, it is understandable that it is a lifetime moment and memory you would cherish forever in your life.

So, if you are borrowing a loan, it's wise to borrow cheaper loans, and personal loans are more affordable than credit cards.

Improving Your Credit Score

Taking out a personal loan and repaying it on time might help you improve your credit score, particularly if you've missed payments on other loans.

If your credit report is dominated by credit card debt, a personal loan might help you improve your "credit mix."

Having a variety of loans and showing that you can manage them appropriately is a bonus for your credit score.

Short Term Borrowing

If you need to borrow for a relatively short time, you may want to consider a personal loan. Personal loans are usually for a short period ranging from 12 to 60 months.

A one-year personal loan, for example, may be used to bridge the gap between a lump sum payment due in a year and insufficient cash flow in the meantime.

When Not To Get The Personal Loan?

You Have Cheaper Alternatives

Even in an emergency, it is always advisable to take a minute to examine alternatives before borrowing. If your credit profile is strong, you may qualify for a 0 % APR credit card.

Medical debt may typically be managed with a payment plan, and your company may give a cash advance on your paycheck.

You Cannot Afford The Debt.

Usually, people opt for a personal loan since it does not require collateral. This leads people to borrow more than they can afford.

While it is true that if you do not have any collateral, the lender cannot confiscate any of your belongings. But, it has a significant impact on your credit score and your chances of getting future loans.

Also, Personal loans are a costly way to finance non-essential purchases such as a lavish wedding or vacation. People tend to borrow personal loans more than they can afford since it is easier to borrow.

Conclusion

Personal loans are unsecured loans that can be borrowed for any purpose. These loans are approved based on your credit score and creditworthiness. These loans usually have fixed interest rates and are short-term.

You can borrow a personal loan for any purpose, but the lender might impose some restrictions. While it is comparatively more accessible and cheaper to borrow a personal loan, it is imperative to compare the alternatives and determine if a personal loan fits your situation.