Personal loans are part of a class of financial instruments available to everyday consumers. The providers of personal loan services include banks, credit unions, and other financial institutions. Several things distinguish these loan services from other forms of financing, and it's good to know the basics before you seek a loan.
Unsecured Financing
By far the biggest distinction between personal loan services and other financing options is the lack of security. In this case, security refers to collateral that's included in the terms of the loan that can be used to settle the debt if the borrower fails to pay it in full. For example, a mortgage is secured by the value of the house that a person is buying or already owns.
All About the Credit Rating
When no security has been provided for a loan, the lender is making its decision based on your history of good faith and your current credit rating. This is why young people are constantly encouraged to build up their credit. The better your credit rating is, the lower the interest rate on your loan is likely to be.
The Prime Rate
Larger economic effects determine the baseline interest rate for personal loans. The number most closely watched by the banks is called the prime rate, and this is the rate at which your bank can borrow money from other banks. Your bank isn't going to give you a better rate than it gives another bank unless you're a billionaire. While an extremely good credit rating will definitely get you closer to the prime rate, the bank will always take a bit of a vig for financing your loan.
Variable vs. Fixed Interest
Long-term loans represent a risk to the banks. Suppose the prime rate shot through the roof over the next year, something that was a real problem as recently as the 1980s when even the safest home mortgages were being financed above 18% interest.
To offset this risk, personal loan service providers may offer a variable rate. This means that the interest rate will rise or fall depending on the prime rate. A variable rate loan may be appealing in an environment where rates are low and dropping, but a fixed-rate loan makes it easier to plan to make payments. Likewise, a fixed-rate loan can be refinanced at a later time if rates drop, but you will incur a service charge for getting a new loan.
