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Personal loans have become a staple in the American financial landscape, serving as a versatile tool to address a wide array of financial needs. From financing a new home or a dream wedding to consolidating debt, personal loans come to the rescue in many situations. With a plethora of lenders and loan products on offer, it can be overwhelming to navigate the diverse world of personal loans.
In this article, we aim to demystify personal loans by exploring the most popular types, delving into their intended purposes, and explaining how they function.
Unsecured personal loans
When speaking about loans, “secured” and “unsecured” refer to the presence or absence of collateral.
Unsecured personal loans are personal loans that do not require any kind of collateral. Without the security of collateral, lenders assess borrowers for personal creditworthiness. Those factors include personal credit score, debt-to-income ratio, and employment status.
There are many unsecured personal loans available to consumers. One popular example is a credit card, which doesn’t require any collateral to use.
Because unsecured personal loans are riskier to lenders, they often come with more stringent creditworthiness requirements. They are also normally more expensive for borrowers. However, they can be more attractive to many borrowers because they don’t require them to put a personal property on the line.
Typically, unsecured personal loans are only given out to creditworthy borrowers. However, unsecured loans come in several forms, including lump-sum personal loans and lines of credit. It’s normally more difficult to get approved for larger loans without providing collateral.
Pros of Unsecured personal loans
- No risk of losing collateral
- A common form of credit
Cons of Unsecured personal loans
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- May come with higher interest rates
- Harder to qualify for in many cases
Secured personal loans
Secured personal loans are personal loans where the borrowers provide collateral to secure the loan. The loans are considered “secured” because lenders are provided security should the loan be defaulted on.
Secured personal loans are normally large loans. However, if a borrower has poor credit, lenders may require collateral for regular personal term loans.
Collateral for secured personal loans typically includes some kind of property. In many cases, the item that the borrower is purchasing. Mortgages and car loans are examples of secured personal loans where the collateral is the item being purchased.
In other cases, you can provide collateral that has nothing to do with the reason you’re getting a loan. The collateral provided is simply meant to cover the risk the lender is taking for providing you with a loan.
Because secured loans are less risky for lenders, they are normally cheaper. Borrowers can opt to provide collateral as a means to get lower rates.
Pros of Secured personal loans
- Often easier to qualify for
- Can be used to get lower interest rates
Cons of Secured personal loans
- The borrower must release collateral if they default
- If the collateral is valuable, asset loss can be more damaging
Variable-interest loans
Variable-interest loans are also known as “adjustable-rate”, or more rarely as “floating rate” loans. Variable-interest loans are loans with interest rates that change over time. Their fluctuations are based on benchmark interest rates or indexes. Those benchmarks and indexes change periodically, so the borrower’s interest rate will change as well.
Some people choose variable-interest loans because their starting rates are sometimes quite low. Also, if interest rates fall, the borrower ends up paying less in interest.
Of course, if interest rates rise, the borrower of a variable-interest loan will end up paying more interest back to their lender. So, variable-interest loans come with a level of unpredictability. However, variable-interest loans also come with interest caps. The interest rate borrowers must pay will never exceed that maximal rate. So, borrowers can be sure that they won’t pay more than that specified rate.
Pros of Variable-interest loans
- Initial interest rates normally lower
- Dropping interest benchmarks results in lower repayments
Cons of Variable-interest loans
- Higher risk
- Interest rates can rise to cap in extreme cases
Fixed-rate loans
A fixed-rate personal loan is a loan with a single interest rate that does not change during the loan’s term. Rates can vary widely, but they don’t change in the middle of the loan’s term.
Fixed-rate personal loans are more popular among borrowers who prefer predictability. If interest rates are volatile, it’s not possible to predict whether variable-rate loans would save a borrower money. In essence, they can go either way. Fixed-rate loans, however, are completely predictable. You can be certain of their exact cost from the start, assuming you’re able to always make your repayments on time and in full.
A fixed-rate personal loan gives a borrower a consistent (standardized) repayment schedule. It’s often chosen by borrowers because it makes budgeting simpler.
One of the most common examples of a fixed-rate personal loan is the standard 30-year fixed-rate mortgage. However, most personal loans come with fixed interest rates. Their primary benefit is protection from the possibility of rising interest rates.
Pros of Fixed-rate loans
- Consistent interest rates
- More stable repayment schedule
Cons of Fixed-rate loans
- Interest rates might not be minimal
Personal lines of credit
Personal lines of credit are a form of rotating credit, like a credit card. It’s a flexible personal financing solution where the borrower doesn’t need to borrow a fixed amount from the start. They simply have a total credit limit. They can then borrow any amount of money up to that limit.
With a personal line of credit, the borrower can borrow on an as-needed basis. Interest is charged once money has been drawn from the line of credit. Then, the borrower needs to pay back the balance plus interest according to the terms of the line of credit.
Lines of credit are often chosen by borrowers who want to fill gaps in their irregular income. So, they can be chosen by self-employed individuals or those with seasonal income fluctuations. It’s also an option chosen by many people who want to finance larger personal expenses, but don’t know the total cost or when they’ll need to make payments.
Pros of Personal lines of credit
- Greater borrowing flexibility
- Interest is only incurred when funds are drawn
Cons of Personal lines of credit
- Total interest cost is more difficult to calculate
- Fees and interest vary widely by lender
Debt consolidation loans
Debt consolidation loans are loans taken out to pay off other debts. Borrowers often take them to pay off high levels of high-interest debt. Once the borrower takes a debt consolidation loan, they immediately pay off other debts. Then, they must pay off the debt consolidation lender.
One of the most common reasons borrowers choose debt consolidation loans is to combine the balances of multiple credit card debts. Credit cards carry very high-interest rates which can snowball quickly. By taking a debt consolidation loan, the borrower can simplify their repayment process. Instead of tracking multiple credit cards, they can track a single fixed-term loan. In some cases, the interest owed for a debt consolidation loan can be lower than those owed for loans they are taken to pay back.
Lastly, debt consolidation loans can be used to save a borrower’s credit score. They can enable borrowers to pay off lingering debts immediately, which is good for their credit score. It simultaneously diversifies their credit utilization.
Pros of Debt consolidation loans
- Can pay high-interest debt back quickly
- Can have a positive and fast impact on credit score
Cons of Debt consolidation loans
- Won’t normally solve financial hardships on its own
- Up-front costs are often high
The Bottom Line
Personal loans come in various forms, each tailored to meet specific financial needs. Whether you require an unsecured loan for flexibility, a secured loan for more significant borrowing, or a debt consolidation loan to manage high-interest debts, there is a personal loan solution out there for you. Each type has its advantages and drawbacks, so it's crucial to assess your financial situation and requirements before committing to any particular loan. By understanding the intricacies of personal loans, you can make informed decisions and secure the right loan for your needs.
Our comprehensive lender overviews can further assist you in finding the most suitable lender for your unique circumstances, ensuring a smoother and more beneficial borrowing experience.
Article Topics
Personal Loans
Myles has been covering trends in personal finance for years. He writes for a number of financial blogs, columns, and fintech startups. With extensive knowledge of business financing and the financial challenges of business owners and individuals, Myles puts his skills to use by providing engaging and useful information.
