Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
In this lesson, we'll explore personal loans. You'll learn about the application process and see how credit score can affect the loan amount, interest rate, and repayment period.
What Is a Personal Loan?
Jan is driving home from work when her car starts to sputter, so she slowly guides it to the side of the road. She calls roadside assistance and has her car towed to a mechanic. After the diagnostic, the mechanic tells her the repairs will cost $750. Jan tells the mechanic that she won't have $750 until payday, in three weeks. The mechanic suggests that she apply for a personal loan at Advantage across the street.
Jan walks to Advantage and is greeted by a loan officer. She tells the loan officer about her situation. The loan officer suggests a personal loan, which is a borrowed sum of money used for any purpose. Personal loans have different maturity dates, a specific time for repayment, and interest. Jan asks, 'What's interest?' The loan officer explains that interest is a fee charged by the lender to loan money, which the borrower pays. Jan replies, 'Okay, I'll apply for a personal loan since I have no other options.'
The Application Process
The loan officer gives Jan a loan application to complete. The application asks for Jan's social security number, address, place of employment, salary, how many years she has been employed, and three references. References are people who know an individual and who are used to confirm personal information and serve as a point of contact in case the individual stops making payments and the lender can't find her. Jan needs to give the names, addresses, and phone numbers of her references.
Types of Personal Loans
As Jan completes the application, the loan officer tells her about the two main types of loans: secured and unsecured. A secured loan is backed by collateral, which is something the borrower owns, such as a car, cash in an account, or a home. An unsecured loan is also called a signature loan where the borrower guarantee repayment of the borrowed amount and principal based on her signature.
Jan finishes the application and the loan officer submits it for review. The officer tells her Advantage will verify the information on the application as well as check her credit score. Credit score is a calculated number based on how well an individual pays her bills. Creditors, or companies an individual owes, send information to credit reporting agencies on how much an individual owes and if she pays on time. The credit reporting agency consolidates this information to create a credit score.
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There are several factors that determine credit score. Generally, if an individual pays her bills on time her credit score will be high (700 or above), while if she pays her bills late she will have a low credit score. If an individual's credit score is low (600 or below), a lender is less likely to approve a personal loan and if she does receive approval with a low credit score, the interest rate on the loan likely will be high. The higher the credit score, the lower the interest rate; the lower the credit score, the higher the interest rate. Additionally, if an individual's credit score is low, she might only be approved for a secured loan and collateral might be required.
Because Jan's credit score is 750, she receives a low interest rate and won't be required to provide collateral. The loan officer tells Jan she's been approved for $1,000, which is called the principal. The principal is simply the borrowed amount or the amount of the loan request. The interest rate is 5%.
'The last component of the loan I'd like to discuss with you is the maturity date,' the loan officer says. The maturity date is the day the loan should be paid in full. The later the maturity date, the more interest a borrower pays, but the smaller the payments. Conversely, the sooner the maturity date, the less interest a borrower pays, but the larger the payments.
Typically, if an individual has bad credit, the maturity date might be later so payments will be more manageable and the lender can make more money. The loan officer tells Jan that because she has good credit, she has the option to repay the loan in one lump sum when she gets paid or over a period of one to three years. Jan decides to take the one-year option.
A personal loan can be used for any purpose, such as emergency car repairs as in our example. The first step in obtaining a loan is to complete an application. Upon review, the lender will assess the borrower's credit score and determine the loan amount, interest rate, and maturity date. Remember, if an individual's credit score is high, the interest rate will be low. However, if an individual has a poor credit score, she will pay a higher interest rate over the life of the loan.
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