(Updated Dec. 2014)
It's happened to everyone: Some unexpected expense pops up, and you don't have the cash to handle it. Your first instinct might be to reach for that credit card, or call Aunt Betty to ask for a loan. However, neither of these options may be ideal. The answer may lie in heading to a local lender and applying for an unsecured personal loan.
Personal loan basics
A personal loan is a monetary advance made to you usually from a bank, credit union or finance company. Most personal loans are unsecured and carry a fixed interest rate.
Maturity terms can vary widely, depending on the lender - some will require that the loan be paid back in as little as six months, while others may allow you as long as 10 years. The right time period for you will depend on how much money you need to borrow, what the interest rate is, and what you can afford to pay back each month.
Personal loans are usually for relatively modest amounts - often from about $1,000 - $10,000, though some may go into the tens of thousands of dollars. How much you can borrow will depend on your financial resources and your credit - and since the loans are unsecured, you'll need to have fairly good credit to qualify.
Personal loans can be set up in one of two ways. You can either borrow a lump sum of cash up front, or you can establish a personal line of credit. The latter sets a certain limit on how much you can borrow, but then allows you to draw against it as needed, in whatever amounts you desire. There's usually an annual fee for a line of credit.
Bank and credit unions are the most common sources for obtaining personal loans, although online banks and lending websites are also great resources for
these types of loans. In some cases you may find it easier to obtain a personal loan at a bank or credit union where you have an established relationship,
such as where you have your checking and savings accounts. However, don't assume you'll get the most favorable rate, fees and terms there - it pays to shop
Shopping for a personal loan
It's always important to compare apples to apples when applying for a personal loan. Request written proposals from at least three different lenders, and compare each on the following:
- Interest rate (Compare this to the cash advance rate on your credit card, too.)
- Annual fees
- Restrictions on prepayments
- Length of repayment schedule
Why choose a personal loan?
With an unsecured personal loan, you'll pay a higher interest rate than you would for a secured loan, such as an auto loan or mortgage. However, the rates still tend to be lower than what you'd pay for a cash advance on a credit card, which is one of the things that makes them attractive. Furthermore, personal loans often come with no closing charges, or upfront fees, so the interest is all you're paying
In addition, since the loan is unsecured, you're not putting anything at risk if you should default - other than your credit rating. By contrast, while a home equity loan may have a lower interest rate, there's also the risk you could lose your home if you fail to make the payments.
What about a credit card advance?
There is one situation where you might want to consider a credit card cash advance rather than a personal loan. That's when you expect to be able to pay the loan off quickly. As you may know, credit card companies often offer cash advances at 0 percent interest for periods of anywhere from six to 18 months.. So if you expect to pay the loan off that quickly, it can be a good option.
The thing to remember is that if you don't pay the loan off by the deadline, you'll suddenly be faced with a very high interest rate - as high as 18-25 percent annually. There's also a fee of a few percent of the loan amount that needs to be paid upfront as well, though you can sometimes avoid this by choosing an option that offers a low interest rate rather than 0 percent over the initial period.
Secured personal loan
There are also options for obtaining various sorts of secured personal loans. Because they're secured, there's much less risk for the lender and the interest rates are considerably lower. Credit requirements are less restrictive as well.
Secured personal loans are often backed by savings accounts, CDs, stocks, bonds or other financial instruments. The loan amount may be limited to the value of the account or financial instrument, or you may be able to borrow several times the value of the asset pledged.
One of the advantages of this approach is that you still get to keep whatever returns the asset generates while it is securing the loan. This makes it a handy alternative to actually withdrawing money from savings or selling the CD, stock or other asset to get the money you need. At the same time, you can't withdraw the funds, cash out the CD or sell the asset until the loan is paid off.
A secured personal loan is a great option for a parent or other relative who wants to help a young person obtain a loan and start building credit. They can put up the collateral, but the loan itself - to buy a car, pay education expenses, etc. - is in the other person's name.
This can be a better option than co-signing a loan because 1) the interest rate is often lower, 2) the loan is in the young person's name alone, so any missed or late payments don't end up on your credit report and 3) you still get to enjoy the earnings from the asset while it's securing the loan. In addition, the young person is building a credit history that can help them obtain their own loans in the future.
Personal loans fall under the credit practice regulations administered by the Federal Reserve Board and the Federal Trade Commission. Unfortunately, the existence of regulations banning unfair or deceptive credit practices doesn't keep everyone on the straight and narrow. Ultimately, your best protection is shopping around and comparing the terms of several different lenders.
So if you need money, don't immediately pull out your credit card or call up dear Aunt Betty. A little research may prove that a personal loan will provide you the funds you need with a structured repayment schedule that you can afford.