Personal loans are a type of installment loan used for many different projects and expenses. Theoretically, you can use the proceeds from a personal loan to financing most purchases, but there are some options that are better than others.
Regardless of what you use your personal loan proceeds for, all personal loans charge interest. At its core, interest is the price paid to borrow money. If you take out a loan, you will pay the lender interest until the entire balance is paid off. But, if you open a CD account or deposit funds at the bank, they will pay interest to you for keeping your money with them.
With credit and personal loans, there is a wide range of interest rates you can be charged, so understanding how interest can impact you and your finances is critical.
Today we will discuss how interest rates impact your loan balance and what you can do to mitigate your interest expenses.
Personal Loans 101
A personal loan is a fixed credit line with a defined term and interest rate.
Let’s say you want to finance a landscape improvement project in your backyard to increase your home’s value, and you don’t want to pay for the entire project out of pocket at once.
You can take out a personal loan to pay for the improvements, and you will have a manageable monthly payment for a stated term. If the project costs $8,000, you can take out an $8,000 personal loan with a 10% interest rate and a 24-month term.
This means you have the same monthly payment for two years, and you will 10% in interest over the life of the loan.
Once you make your final payment, the account will close, and you will not need to pay on it anymore.
What is Interest?
As we mentioned earlier, interest is the price paid to borrow money. However, interest rates can vary wildly depending on numerous factors, including your credit score, income, lender, and more.
For example, a mortgage may charge 4% in interest, a credit card may charge 22% in interest, and a payday loan may charge 500% in interest or more.
Since these are very different loans with different structures, it can seem difficult to compare apples to apples. Although 4% on a mortgage seems low compared to 22% on a credit card, that 4% may be on a $300,000 loan which is much more than 22% on a $2,000 credit card balance.
When you are comparing interest rates, make sure you are comparing apples to apples, such as personal loans to other personal loans. This will help you identify an accurate estimate of the interest rates you qualify for.
One of the best ways to save money on interest with personal loans is to be selective and work with reputable lenders. Some lenders do not require any credit or background checks to be approved for a loan, but this practice often comes at the price of a higher interest rate.
Since lenders take on risks whenever they issue a new loan, they need to charge interest accordingly to justify their risk.
Although you can work with a lender who does not check your credit, you may want to work with an online marketplace lender who will check your credit but give you a lower interest rate, especially if you have a solid credit history.
Another benefit of working with an online lending marketplace is choosing from a larger pool of lenders so you can pick the loan that fits your needs best.
Borrow What You Need
Before you fill out your loan application, make a detailed estimate of how much you need to borrow. Whether you are building a new porch or consolidating a handful of credit cards, it’s important to borrow the amount you need to achieve your goals without borrowing too much excess. Borrowing excess money will only incur more interest charges over the life of the loan without providing extra benefits.
One of the most powerful benefits of a personal loan is the ability to consolidate debt from other loans and credit cards at a lower rate into one monthly payment. Imagine you have three or four credit cards with high balances charging a revolving rate of 22%; your balances could quickly balloon to be unmanageable, so consolidating them into one personal loan may be a very effective strategy.
Depending on your credit and eligibility, you could combine all of these balances into a single loan charging 9%-11%, which would cut your interest in half.
Hopefully, you can see the benefits of a personal loan and how you can save money on interest
using a few simple strategies.
If you want to learn more about personal loans and how you can use them effectively, please check out our other guides and reviews!
* This content is not provided by the financial institution or the offer’s provider. Any opinions, analyses, reviews or recommendations expressed here are those of the author’s alone, and does not constitute a financial or expert advice.