Personal Loans

How do Personal Loans Function?

If you require money to purchase a car or to pay off an existing expenditure, a personal loan could represent the perfect option. In truth, most of us will require these financial vehicles at least once during our lifetime and many employ loans on a somewhat regular basis in order to enjoy a superior level of liquidity. There is nonetheless a slight stigma surrounding these vehicles and phrases such as “debt” and “default” will often detract from the benefits associated with the loans themselves. Let's attempt to do away with these and other misconceptions by quickly examining the ways that such loans function before looking at some of the most common variants currently available.

The Mechanics Behind a Typical Personal Loan

The core concept behind any type of personal loan is rather simple. The individual (borrower) speaks with a financial institution (known as the lender). He or she requests a certain amount of money. Assuming that their credit is positive, the institution will provide this money in the form of a liquid loan. A certain amount of monthly interest is attached to the loan itself. This interest must be repaid with the initial amount requested (known as the principal). Assuming that these conditions are met, it will be possible to request an additional loan. If the borrower happens to miss numerous payments or simply refuses to settle (commonly known as a default), credit reporting agencies and even debt collectors may become involved. Still, personal loans are often necessary in order to purchase goods or services that would otherwise prove to be too expensive in relation to the funds contained within a typical bank account.

Unsecured Personal Loans

Unsecured personal loans are lending vehicles that will not require any type of collateral. In other words, you will be approved for a certain amount of money without needing to use your home, car or other valuables as a negotiating factor. Unsecured loans are generally reserved for those who are associated with extremely high credit scores (the banks are not likely to lose money in terms of a default). Those with poor personal credit or a bad history of repayments will likely need to request a secured personal loan, which brings us to the next topic.

Secured Pesonal Loans

A secured personal loan is associated with some form of collateral. For example, let's imagine that you need a specific amount of money to purchase a new vehicle. If your credit rating is less than perfect, the lender will require some means to recuperate the funds in the event that they are lost due to a default. This is known as a “secured” loan, as the money is secured against collateral of a specific value. This is also the most common type of loan currently on the market.

The Difference Between Fixed and Variable Interest Rates

You have likely seen the terms “fixed” and “variable” APR when examining the different types of personal loans. What do these phrases signify and why are they important factors to keep in mind?

Fixed interest rates guarantee that the rates will not change during the lifespan of the loan. The main advantage here is that you will know exactly what you are expected to pay each month. You are also made aware of the aggregate amount (the principal and the interest) that will be required at the end of the loan itself.

Variable interest rates will change depending upon the decisions of the Federal Reserve. While this can be a a great scenario if the rates happen to lower, the exact opposite is also true. Increase rates could signify that you are actually obliged to pay much more than you initially anticipated. This is why choosing a variable rate personal loan should only be done after having performed an adequate amount of research.

When Should You Apply for a Personal Loan?

Assuming that you do not have sufficient liquidity to complete a major purchase, a personal loan could be a wise choice. However, avoid these vehicles if you already have outstanding debt. You could only dig yourself deeper into a financial “hole”. If you are ever in doubt, speak with a certified adviser in order to better appreciate your options. These loans can be amazing vehicles if they are used in the correct manner.