Loans are a financial product that can be used to finance expenditure that an individual could not or would not otherwise fund with cash. There are many reasons why individuals tend not to use cash for expenditures going over a certain amount.
For instance, an individual may not have enough cash to fund certain expenditures like a holiday trip. Some individuals may have the required cash but may still want to take out a loan, particularly when the expenditure is expected to be in deferred payments. For instance, people tend to lease out their cars even if they can pay outright for them, simply because they do not want to pay the lump sum amount in one go. Monthly lease payments seem lighter on the bank account.
However, one can discuss the merits and demerits of such a decision because paying off the lump sum amount right away can help save the interest payments over the long term. However, if the lump sum payments are not made, then they can be invested and used to earn a return over the period.
Loans can be broadly divided into two main categories.
Secured loans are those loans that are secured by collateral. The collateral can be any asset belonging to the borrower. Secured loans minimize the risk of loss for the lender. Certain loan types, such as mortgage and lease loans, have to be secured because these loans are for high-value assets.
Other loans such as credit card debt and personal loans can be both secured and unsecured, depending on the individual’s creditworthiness taking out the loan. Secured loans usually carry a lower rate of interest than unsecured loans because the risk for the lender is mitigated through the collateral.
Unsecured loans are those loans that are not secured by collateral. Since the risk of loss for the lender is high, the interest rates for unsecured are also higher than secured loans. For variable rate unsecured loans, the rate applicable on loan is determined by the borrower’s creditworthiness.
Usually, unsecured loans are available for individuals with high credit scores. Unsecured credit cards and unsecured personal loans are two of the most common examples of unsecured loans. Whereas Peer peer and online loans are also unsecured loans, these target individuals with relatively low credit scores.
Now that we have a general understanding of the two main types of loans let us discuss personal loans.
Personal loans, as discussed above, can be either secure or unsecured. This depends on the lender and the borrowers. Usually, the banks offer unsecured personal loans; however, the banks can also arrange for secured personal loans if the borrowers ask for a secured loan specifically.
Personal loans can be considered a default type of loan that can be used for any particular reason. For instance, mortgage loans can only be used for buying a house; a lease can only be used to buy the car it is taken out for. However, personal loans do not have to stick to the purpose for which they are taken out.
Banks may ask the reason for which a client is taking out the loan. This question may simply be a part of the standard operating procedures of the bank. This, however, does not mean that the borrower has to stick to the stated objective.
Personal loans can therefore be taken out for any reason, as long as it is legal.
Personal loans comprise of
The interest rate on personal loans may be fixed or variable. The banks usually offer both options to the borrowers, who decide which option is more suitable.
Fixed-rate personal loans may be good in a condition where the interest rates fluctuate a lot or are expected to increase in the future. If we look at the current situation of interest rates, we can see that the United States’ interest rates are at an all-time low. So there is a very high probability that in the future, as the U.S economy recovers from the Covid-19 induced economic recession, the FED may increase the rates by 25 to 50 or more basis points over the next 12-18 months. In this situation, it may perhaps be best to go for a fixed-rate loan.
Variable-rate personal loans may be good in a condition where the interest rates are expected to fluctuate towards a more favorable position. For instance, if presented the interest rates are high and are expected to fall in the future, then the borrower will benefit by signing up for a variable rate loan and thus benefit from a reduction in the interest rates.
Banks usually carry out credit checks before lending out any personal loan. It is usually easiest to get a personal loan if the borrower has a bank account with the lending bank. However, new clients can also get a personal loan, but the bank will most likely carry out a more thorough credit check to minimize the risk.
The credit score should at least be good for a personal loan. This means that it should be above 550-600 level. Any individual with a score below this level will not be able to get a personal loan.
Personal loans are offered by lending institutions such as
Banks are usually the first lending option that borrowers turn to. Both high street and small-sized banks usually have dedicated departments that handle all of the loan application and processing, which makes getting a personal loan from a bank very fast and efficient. However, the initial paperwork may be a bit of a hassle.
There are different types of banks that a borrower may look into for getting a personal loan. Your first option should be your bank, where you have a bank account. It is likely that if you have a good working relationship with your branch manager, or if you have a good person of contact at the bank, then you can get a very good deal out of the personal loan.
However, the bank where you have your account may not be the best option if other banks offer personal loans with lower rates and better features. If you are looking for cheaper rates, it may be worth trying out an online bank.
Online banks are completely online banks; thus, like brick and mortar banks, they do not have branches where you can walk into. Online banks operate through their main head office; customers and clients have access to the bank through the website, application, and telephone lines.
Since the online banks do not have the additional costs of maintaining the branches, staff, and other associated relevant costs, online banks tend to offer better rates on both deposits and lending.
Online banks may also provide faster and more efficient service to their customers since they have fewer matters to focus on than a conventional brick and mortar bank. Thus, an online bank may be a good option for getting a personal loan. However, they may look for individuals with high credit scores to minimize their own risk.
Credit unions are also good lending options for personal loans. However, the access to them is restricted only for the members of the credit union. A credit union is owned by the people who have accounts in that union, so the borrower may be required to fulfill the prerequisites to becoming a member of the credit union before benefiting from the personal loans offered by the credit union.
A credit union may offer personal loans at lower than market rates to the members. This is one perk of being a member of a credit union.
Online lending sites are another very great source of personal loans. They rank right up there with banks in terms of speed and efficiency. The online lending industry is a multi-billion dollar industry in the United States, and it has, in the last decade, become a vital industry that has sustained the small and medium business industry.
Individuals and small businesses can take out personal loans from online lending sites. The difference between a bank/online bank and an online lender is that the online lenders are not banks. Secondly, most online lenders have slightly higher than market interest rates, which makes online lenders a more expensive option than banks.
The catch, however, is that online lenders focus a lot on the creditworthiness of individuals. If you have a high or excellent credit score, then you can get a low-interest rate, which may be at par with the banks or in some cases lower than banks.
Thirdly, online lenders are known for their services and extremely fast and efficient application process. Most lenders have online applications that take hardly 5-10 minutes to complete, and in a matter of 24-48 hours, the borrowers can get access to the funds.
Online lending sites are known for their processing times, features, and customer services. Thus lenders who cannot get a personal loan from their bank can turn to online lenders. If one factor had to be chosen that differentiates online lenders from banks, then in our opinion, that would be the convenience of accessing the funds.
Peer to Peer lenders are also online lending platforms. They are also more commonly known as social lenders. P2P platforms allow lenders and borrowers to come together on a platform without intermediary i-e the bank. This makes P2P loans cheaper as compared to banks since the costs of the intermediary are not involved.
The lenders on P2P sites are individuals and also at times, institutional lenders. The lenders can earn a return on their investment on P2P sites, in the form of interest, whereas the borrowers can get cheaper than market loans.
P2P sites, however, focus a lot on the creditworthiness of the borrowers. So if the borrower has a high credit score, they may be able to get a good deal out of the personal loan. However, individuals with lower credit scores may find it difficult to secure a personal loan with low rates.
P2P lenders are also considered as lenders of last resort. Usually, people turn to P2P lenders when they have run out of other options.
As stated above, personal loans can be used for any reason as long as it is not illegal. Borrowers do not have to stick to the stated purpose. Some of how personal loans can be utilized have been discussed briefly below.
Most people use the personal loan facility available through their local bank to fund their holidays. This may not be the most responsible way to use a personal loan, as it is never a good idea to use debt to fund holidays.
Many people use personal loans to pay off high-interest credit card debt. This is a recommended use of personal loans by many financial experts. If you have a high-interest debt on a credit card and are struggling to pay it off, then taking out a personal loan can wipe the debt off. Thus, they prevent more interest from accruing on it and potentially saving the credit report from being marked negatively due to late payments. However, one must also have a strategy in place to pay off the personal loan.
This is also a very clever use of the personal loan. An emergency fund is an important part of any personal financial management strategy. However, it takes time to create an emergency fund. An average individual can take around a year to create an emergency fund with up to $50,000 in savings. If an emergency strikes during this time, the personal loan can be used as an emergency fund.
If any individual has multiple low-value loans, for instance, credit card debt, payday loans, and P2P loans. Then a personal loan can be taken out to consolidate the debt and pay off the smaller loans. Doing so will make it easier for the borrower to focus only on the personal loan payment instead of multiple smaller loans with varying rates of interest.