Unsecured personal loans are installment loans, which means you borrow a set amount of money for almost any personal use and repay it, with interest, in fixed monthly payments until it’s paid off.
Unlike other types of installment loans such as auto and home loans, unsecured personal loans don’t use the item you’re purchasing as collateral. Instead, the loans are granted based primarily on your creditworthiness.
But that doesn’t mean your lender can’t recover its losses if you stop making your payments. The lender may send your account to a collection agency, take you to court to try to get your wages garnished, or attempt to seize your property to pay your debt.
To avoid those scenarios, it’s important to understand how personal loans work and whether they’re the best choice for you. Here are a few things to consider before you make your decision.
Lenders want to be reasonably confident you’ll be able to repay your debt on time. So before approving your loan application, they’ll measure that risk by examining a variety of factors. In general, when you apply, a lender will review the following information to determine whether you qualify for an unsecured loan — and, if so, what the terms will be:
Credit scores. Your credit scores help lenders predict how likely you are to repay a debt. You can often qualify for lower interest rates and higher loan amounts when your scores are high.
Income. Lenders want to know if you make enough money to repay the loan.
Debt-to-income ratio. This ratio compares the debt you currently have to your monthly income. Lenders use it to determine whether you have too much debt to handle another loan. The lower your ratio, the better.
If you don’t qualify for an unsecured personal loan, you may want to consider applying for a secured loan. Because secured loans are backed by collateral, they’re typically easier to get for those who have property that counts as collateral.
A variety of lenders offer both secured and unsecured personal loans to qualified applicants. If you’re thinking about getting one, it makes sense to shop around to find the lowest rates and fees, as well as the best lender relationship for your needs.
Traditional banks. With a network of branches, a traditional bank might be a good choice if you like to talk to someone in person when you have a question or problem. For those times when you can’t make it to a branch, many banks have technology that allows you to check your loan balances and pay your bills online.
Credit unions. If a personal relationship with a community-based organization is what you desire, a credit union could be your best bet. That relationship could also make a local credit union more willing than other lenders to work with you.
Online lenders. If in-person service isn’t important to you and you want the convenience of completing your entire loan application from your couch, an online lender may be the way to go. Many new online lenders have appeared in recent years. If you decide to work with one, make sure it’s reputable. Read online reviews and check the Consumer Finance Protection Bureau’s online complaint database.
Peer-to-peer lenders. Like online lenders, peer-to-peer lenders operate online. But loan funding comes from individual investors who profit from the loans they fund. When evaluating this type of lender, pay attention to fees. They could be higher than those charged by banks and credit unions.
Ultimately, the lender that’s right for you is the one that offers the best rates and lowest fees with a loan length that make sense for your lifestyle and budget, all while providing a level of customer service you’re comfortable with.
An unsecured personal loan might be the right choice when you need cash for a specific purpose. For example, if you have high-interest debt, you may want to consolidate it into a personal loan with a lower interest rate to help lower your monthly debt payments. A personal loan could also help you pay for unexpected emergencies like replacing a broken heating unit in the middle of winter.
But the money shouldn’t be used to pay for things just because it can be. Using personal loans to pay for things you want — such as a vacation or big-screen TV — instead of what you need is rarely a good idea. Taking on unnecessary debt can put a long-term strain on your finances and hurt your financial health. For luxuries it’s best to wait, save up the money, and then make your purchase.
You may also want to consider other options. For example, if you have good credit, you could qualify for a balance transfer credit card with a 0% introductory offer. If you’re a homeowner, a home equity loan or line of credit could also provide the extra cash you need. These alternatives might allow you to borrow more at lower interest rates.