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How Do Personal Loans Work?
Personal loans can be an important part of financial planning, offering people a flexible means of obtaining money for almost any use. One reason that so many people like them is that they are straightforward and predictable. When you understand how personal loans work, you can be comfortable weighing the pros and cons of loan terms, repayment options and other parts of this popular personal finance tool. Let's start by detailing the process of applying for a personal loan.
How do personal loans work for borrowers?
When borrowers apply for personal loans, they begin a financial transaction that involves several key steps and considerations.
Here's what to expect when trying to get approved for loans:
Assess your financial needs
Before you apply for a personal loan, evaluate your financial situation, identify your need for borrowing money and determine how much you can afford to borrow based on your income and expenses. Overborrowing can lead to financial strain and difficulties with repayment. Borrowing too little will leave you short of your goals and looking for new options. Check your credit score to get an idea of how the bank will assess your creditworthiness. This will affect your chances for approval as well as how much you can borrow and the interest rate.
Look at your options
Keeping in mind all the information you have gathered, look at the different lenders you might apply to. Look at the interest rates they offer and check to see if they charge any fees, including application fees, origination fees, late payment fees and early repayment fees. Check online reviews for the lenders, too. If you have a checking account or some other type of account with a lender, see if that lender has any special loan offers for current customers.
Complete the loan application
You start the process by filling out an application. You will need to give information about your identity, employment, income and existing debts. TD Bank allows you to get personalized loan options with no commitment or impact on your credit score. If you like the terms you can apply immediately, and a hard credit inquiry will occur when you apply, which may have an impact on your credit score.
Loan approval or denial
Lenders assess your creditworthiness based on factors such as credit score, debt-to-income ratio, employment history and overall financial stability. A positive credit history generally results in more favorable loan terms, including lower interest rates and higher loan amounts. The lender will inform you of the decision. If a loan application is denied, the lender is required to send you a letter explaining why. You also are entitled to a free copy of your credit report from the credit reporting agency. It's a good idea to review the report and look for any problems that can be addressed to boost your chances of approval.
Accept the loan terms
If approved for a loan, you'll receive a loan offer detailing the interest rate, fees, loan amount, loan term and monthly payment amount. Review these terms carefully, check the total cost of borrowing, and make sure you can comfortably manage the monthly payments before you accept the loan.
Repayment
Upon accepting the loan terms, borrowers commit to making regular monthly payments according to the agreed-upon payment schedule until the loan is fully repaid. This includes paying both principal and interest, with the payment amount determined by factors such as the loan amount, interest rate and loan term.
How do personal loans work for lenders?
From the lender's perspective, offering personal loans involves a thorough evaluation of loan applications and managing the lending process through the life of a loan.
Here's a deeper look into how personal loans work for lenders:
Review loan applications and qualifiers
Lenders review a loan application to assess the borrower's overall financial health, including debt-to-income ratio, savings, employment history and income. The lender checks with one or more of the credit bureaus to get a credit report and credit score. Based on all that information, lenders assess the credit risk posed by each borrower.
Accept loan application
Upon accepting the loan application, the lender determines the interest rate, loan amount and loan terms to offer. Low-risk borrowers may qualify for lower interest rates and higher loan amounts, while high-risk borrowers may face a higher interest rate or receive lower loan amounts. If the borrower agrees to the loan offer, the lender disburses the funds to the borrower's designated bank account. The borrower is now responsible for repaying the borrowed amount plus interest.
Interest application
Throughout the life of the loan, lenders apply interest to the outstanding loan balance. The interest is typically charged as a percentage of the remaining principal balance. The lender sends monthly statements to the borrower or manages automatic withdrawals if that has been set up. The lender also tracks payments received, sends the credit bureaus updates on the borrower's repayment progress, and manages delinquencies or defaults according to established policies and procedures. Effective repayment management helps lenders mitigate risk and maintain a healthy loan portfolio.
What to know about your loan
Understanding the workings of a personal loan is an important part of good financial management. Knowing just the basics can help you manage your money and avoid budgeting pitfalls. Here are key points to know about your loan:
- Interest rate. The interest rate determines the cost of borrowing and directly impacts the total amount repaid over the loan term. Lower interest rates result in lower overall costs, while higher rates lead to higher repayment amounts. Personal loans usually have a fixed interest rate, which means the rate stays the same. You can plan on having the same payment for the life of the loan
- APR. The Annual Percentage Rate (APR) gives a fuller picture of the cost of borrowing money by including fees that some lenders charge. The APR for a personal loan is the interest rate you pay per year when you include the fees plus the interest charged over the life of the loan. It allows consumers to easily compare loan offers with different interest rates and fees
- Monthly payment amount. The monthly payment amount includes both principal and interest. It must be made on time and in accordance with the loan agreement
- Monthly payment due date. If you miss the monthly payment due date, you could be subject to additional fees and increased interest charges. Paying late or missing a monthly payment which may potentially negatively impact your credit. Setting up automatic payments or reminders can help you stay on track
- Loan term. The loan term refers to the period over which the loan is repaid. Longer loan terms may result in lower monthly payments but can lead to higher overall interest costs, while shorter terms often have higher monthly payments but lower total interest expenses. With TD Bank there are no prepayment penalties, so you can pay your loan off early with no prepayment fee or penalty
Types of personal loans
There are two primary types of personal loans. Let’s go over the details of both.
Unsecured personal loans
Unsecured personal loans do not require collateral, which serves as a form of financial security for the lender in case the borrower defaults on the loan. Approval is based solely on the borrower's creditworthiness, income and financial stability. Because no collateral is involved, these loans pose a higher risk to lenders. As a result, unsecured personal loans typically have higher interest rates compared to secured loans. Borrowers with strong credit scores and stable incomes are more likely to qualify for unsecured personal loans.
Secured personal loans
Secured personal loans require collateral, which may be a car, real estate, cash, a non-retirement investment account or some other asset. By putting up the collateral, borrowers reduce the risk for lenders, which often leads to lower interest rates and more favorable loan terms. However, if the borrower fails to repay the loan, the lender has the right to seize the collateral to recover the outstanding debt.