Personal Loans - How do they work

A personal loan offers you a way to borrow money and repay it through regular installments over a set period. Your payments cover both the amount borrowed (the principal) and additional interest. What do people use personal loans for?

When you apply for a personal loan, lenders often want to know why you need the funds and how you plan to use them. Personal loans can typically cover various expenses, such as:

• Home renovations

• Purchasing a new car

• Costs related to divorce

• Unexpected emergencies

• Wedding expenses

• Holidays

• Debt consolidation

• Medical expenses

While many lenders offer flexibility, some may have restrictions on specific uses. For instance, there might be limits on using a personal loan for funding undergraduate education, investing, or covering everyday living expenses.

How do personal loans work?

When you're approved for a personal loan, the lender provides you with a lump sum of money that you repay in regular installments along with interest. The interest covers the cost of borrowing.

Lenders consider several factors—like your credit score, income, debt-to-income ratio, and how you plan to use the funds—to determine your eligibility for a personal loan.

Repayment terms can range from several months to several years. Whatever you choose, it's important to ensure the monthly payments fit comfortably within your budget.

Pros and cons of personal loans

Benefits of personal loans include:

• Being able to fund large expenses faster. You can spread the repayments over several months or years, making budgeting easier.

• Repayments are typically fixed, providing stability in your financial planning.

• Provides fast access to cash when you need it most.

• Flexible loan terms allow you to choose a repayment period that suits your financial situation.

Drawbacks of personal loans include:

• Longer repayment terms can increase the total cost of borrowing due to accrued interest over a longer period. 

• Missing or delaying repayments can negatively impact your credit score. 

• Fees and penalties associated with personal loans can be significant.

Secured and unsecured personal loans

Most personal loans are 'unsecured,' meaning they don't require collateral like a house or car. 

On the other hand, 'secured' loans are backed by assets, which can sometimes lead to larger loan amounts and lower interest rates. However, it's important to remember that with secured loans, if you're unable to repay, the lender may reclaim the asset to cover the loan.

How much should you borrow on a personal loan?

Before you apply, it’s helpful to sit down and carefully budget for your upcoming expenses. For example, if you're considering a loft conversion, factor in costs like materials, labour, and installation. Creating a detailed budget will give you a clear picture of your borrowing needs and help you calculate what you can comfortably repay each month.

How do I qualify for a personal loan?

Understanding how to qualify can feel overwhelming, but it doesn't have to be. Here are a couple of important tips to help you.

Passing a credit check

Your credit score plays a crucial role in lenders' decisions. It reflects your financial reliability, showing whether you've managed credit responsibly in the past. A lower score might indicate missed payments or financial challenges, while a higher score suggests good financial habits. 

Generally, a higher credit score increases your chances of loan approval and often comes with lower interest rates.

Income

Your income is a key factor in determining your ability to handle monthly loan payments. 

Lenders often assess your debt-to-income ratio, which shows what portion of your income is already allocated to debt repayments each month. A lower ratio suggests you're less financially stretched and more likely to manage repayments comfortably.

Some lenders may set minimum income thresholds, or a bank might ask you to consider transferring your banking services to them before approving your loan application.

Is a personal loan a good idea?

It's ideal when it offers the lowest annual percentage rate (APR) compared to other financing options. It's crucial to assess monthly payment affordability to avoid late fees and prevent damage to your credit score. 

Additionally, as personal loans are unsecured, it eliminates the need for collateral and the risk of losing your assets due to missed payments. 

Finally, if you require quick access to funds, personal loans are often one of the fastest options, with many lenders approving and disbursing funds within days.

Before you finalise anything, make sure to shop around to compare interest rates, loan amounts, and borrowing terms. This way, you can find the personal loan that fits your needs best.