At some point, everyone might need to take out a personal loan—whether it’s to buy a new house, a car, or to manage unexpected expenses. In fact, personal loans in the U.S. have reached a record high of $143 billion in outstanding debt. But navigating the world of personal loans can be confusing, especially when unfamiliar terms start popping up. Knowing what these terms mean can help you make smarter financial choices and avoid potential pitfalls. Here are 10 essential terms you should understand before applying for a personal loan.
1. Debt-to-Income (DTI) Ratio
The Debt-to-Income (DTI) Ratio is a key number that shows the percentage of your income that goes toward paying off debts. Lenders look at your DTI to see if you can handle more debt. A low DTI (under 36%) is ideal, as it suggests you have enough income to cover additional loans.
2. Loan Term
The loan term is the length of time you have to repay your loan. Personal loan terms typically range from 1 to 7 years, depending on the lender and your financial situation. Keep in mind that a longer term means lower monthly payments but higher total interest costs over the life of the loan.
3. Secured vs. Unsecured Loans
A secured loan requires collateral, like a car or home, to back the loan. If you can’t make payments, the lender can seize the asset. Because the lender’s risk is lower, these loans typically have lower interest rates. An unsecured loan, on the other hand, doesn’t require collateral. While easier to get, these loans often have higher interest rates because they pose more risk to the lender.
4. Annual Percentage Rate (APR)
The Annual Percentage Rate (APR) is the total cost of borrowing money annually, expressed as a percentage. It includes the interest rate and other fees, such as origination fees, making it a crucial figure to consider when comparing loans. A lower APR means you’ll pay less over time.
5. Debt Consolidation
Debt consolidation involves combining multiple debts into one new loan, often with a lower interest rate. It’s a popular option for those with high-interest credit card debt, as it simplifies payments and can reduce overall interest expenses. However, it’s important to avoid taking on new debt after consolidation to truly benefit.
6. Origination Fee
An origination fee is a one-time charge by the lender for processing your loan application. This fee can be a percentage of the total loan amount or a flat fee. Make sure to include this cost when calculating your total loan expense.
7. Fixed vs. Variable Interest Rates
Fixed-rate loans have interest rates that stay the same for the entire loan term, making monthly payments predictable. In contrast, variable-rate loans can change over time based on market conditions. While variable rates might start low, they can increase significantly, making budgeting tricky.
8. Refinancing
Refinancing means replacing your current loan with a new one, usually to get a lower interest rate or extend the loan term. People often refinance mortgages, car loans, or student loans to reduce their monthly payments or to access cash by tapping into their home equity. Just be aware of any closing costs or fees that could offset your savings.
9. FICO Score
Your FICO score is a major factor lenders use to assess your creditworthiness. Ranging from 300 to 850, a higher FICO score means better credit. It affects not only your chances of loan approval but also the interest rate you’ll get. Aim to keep your score in the good to excellent range (670 and above) for better loan terms.
10. Hard Credit Inquiry
A hard credit inquiry happens when a lender reviews your credit report to decide if you’re eligible for a loan. Unlike a soft inquiry (used for pre-qualification), a hard inquiry can slightly lower your credit score for a short period. It’s a small effect, but multiple inquiries in a short time can add up.
Understanding These Terms Can Save You Money
Knowing these terms will help you feel more confident when discussing personal loans with lenders. It also ensures that you understand what you’re getting into and avoid costly mistakes. Whether you’re looking to consolidate debt or need extra cash for an emergency, having a solid grasp of personal loan jargon will make the entire process smoother.
By educating yourself, you’re setting the foundation for making informed financial decisions that will benefit you in the long run.