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How do personal loans work? Here’s the process in 7 simple steps
Find out how personal loans work and what you'll need in order to apply for one.
Personal loans are a relatively common financial need. If you’ve never borrowed one, it may seem a little complex. Lenders often require a lot of information, and finding the right financing can take time.
Before you start your research, you’ll need to know how much you want to borrow and for how long. Once you’ve determined this, you can start comparing options to find the best personal loan for your unique situation.
How do personal loans work?
Personal loans are similar to other types of loans: You borrow money from a lender to pay for personal expenses, which you eventually repay with interest and fees.
Before applying, you first need to figure out what type of personal loan you want. Compare lenders offering that loan type, making sure you’re eligible. Once you’ve found your match, get all of your documents together and fill out the application.
How long it takes for your lender to get back to you depends — it can be anywhere between a few hours and a few weeks. If you’re approved, you should receive your funds shortly, after which your repayments will start. Your loan is closed once you have paid off your balance in full.
After you’ve decided what type of personal loan you want to apply for, here’s how to compare the personal loan offers from different lenders:
- Loan amount. What is the minimum and maximum amount the lender lets you apply for and is it enough?
- Loan terms. What are the minimum and maximum loan terms? Usually terms of between one and seven years are available, but terms differ between providers.
- Fees. Check for upfront fees such as administrative or loan disbursement fees and ongoing fees such as monthly or annual fees.
- Interest rate. Is the rate fixed or variable? Is the rate competitive when compared to other lenders offering similar products?
- Repayment amount. Once you know your loan amount and terms, you can use a loan repayment calculator to see if the repayments will be affordable on your budget.
- Repayment terms. Can you choose your repayment schedule? Can you make extra repayments without a fee? Can you repay the loan early without penalty?
The personal loan process
Jump ahead to one of the steps in the personal loan process to find out more about it.
Step 1: Loan Choice
Finding the right personal loan is the first step of the process. Choosing a loan type will depend on what you need to use the loan for, as well as your current financial situation and your creditworthiness. There are four main types of personal loans you’ll need to consider before making your decision.
Compare your personal loan options
Step 2: Eligibility
Lenders have set minimum eligibility criteria for their personal loans. While it varies by lender, many require borrowers to meet similar requirements, including:
- Age. You’ll need to be at least 18 years of age, or the age of majority in your province or territory.
- Income. You may need to earn over a certain amount to be eligible to apply for a loan. Your lender should list any annual income requirements.
- Employment. Most lenders will require you to be employed and working a stable job. Some lenders may consider alternative forms of income such as government benefits, retirement or investments.
- Residency. Most lenders will require you to be a Canadian citizen or a permanent resident with a valid Canadian address.
- Credit score. Although online lenders often weigh credit scores differently than traditional lenders like banks and credit unions, you’ll still have to meet a minimum credit score in order to qualify for many personal loans.
Just because you meet these requirements doesn’t mean you’ll be approved for a loan – remember no loan is guaranteed. You’ll need to be able to afford what you borrow without straining your budget. Lenders will look at your income, outstanding debts and employment in order to determine if you’re an eligible applicant.
Step 3: Application
The application process for a personal loan differs between lenders. Many lenders give you the option to apply online, at a branch or over the phone. On the lender’s website, you can usually browse a list of documents and information required to complete the personal loan application.
You can expect lenders to ask for the following information in order to process your application:
- Government ID. You’ll need to provide your driver’s license, passport or another form of government-issued identification when applying for a loan.
- Proof of income. Depending on the lender, you may need to provide three to six months of pay stubs or bank account statements. If you’re self-employed, lenders may request tax returns from the last two years.
- Other financial documents. If you have other debts, such as loans or credit cards, you may need to provide statements from those accounts.
- Social Insurance Number (SIN). Lenders may request your SIN to confirm your identity.
Online applications usually take just a few minutes to complete if you have all your information handy. Applying over the phone or at a branch takes a bit longer, but you’ll have someone there to help you through any confusing steps.
Step 4: Approval
Some lenders can give you an answer instantly while others may take a few days or weeks to approve you. There are two forms of approval: full approval or conditional approval.
Conditional approval usually takes less time because the lender is simply assessing your strengths as a borrower. The loan offer is pending provided you offer more information, such as additional pay stubs or documents relating to your assets or debts. The lender will still need to fully underwrite your application and check your credit before issuing full approval.
Full approval is given when you have supplied sufficient information for the lender to make a decision on your application. Your lender will provide you with a loan contract or loan agreement that outlines how much you’ll be borrowing, how much you need to pay back and other important details regarding your loan.
Step 5: Loan funding
Your loan can be funded in a number of ways depending on the loan type and purpose. For example, when you take out a car loan, the lender may pay the car seller directly. This is often the same case with loans for debt consolidation as well, where the lender will pay off your debts directly.
If you’re borrowing an unsecured personal loan, the funds will be sent to the bank account you provide. It generally takes a few business days for the loan to be transferred, and you may be able to sign up for automatic payments in order to reduce your interest rate, or at least to simplify the payment process.
Step 6: Repayment
Most repayment terms are monthly. Some lenders only function online and so only accept direct payments from your bank account, while others will allow you to pay back your loan via cheque or money transfer.
If you plan on making extra payments toward your loan or paying it off early, make sure your lender doesn’t have restrictions on how much you can pay per year and that it doesn’t have any early repayment penalties.
Step 7: Loan closure
If you’re simply making your payments as set out in your loan contract, then your loan should be closed following your final payment.
However, if you’re planning to repay your loan early, it’s a good idea to call the lender and get a final payout figure if you’re getting close to paying off your loan. This is to ensure the loan will be closed when you make your final payment and you won’t be charged any unexpected interest.
4 common personal loan traps
- Insurance. Some lenders try to tack on life or unemployment insurance policies into your loan documents. While having insurance can be beneficial, these policies can also be expensive and make your loan unaffordable. If you’re interested in life insurance, be sure to do some research first before agreeing to a plan.
- Early repayment penalties. You likely won’t be able to save on interest if your loan comes with a fee for paying it off early. Early repayment fees, also known as prepayment penalties, are a way lenders try to get as much of a return on your loan as they would have if you stuck to the whole term.
- Precomputed interest. This type of interest is added to your loan balance before you start making payments, rather than accruing over time. Precomputed interest means you can’t save on interest if you repay your loan early and essentially acts like a built-in early repayment penalty.
4 personal loan secrets
1. Rates aren’t everything
The interest rate of a personal loan is only one factor and may not actually give you the full picture of what your loan costs. The fees and type of interest rate should also be considered alongside the rate percentage so that you can see how much the loan will actually cost throughout the term.
The Annual Percentage Rate (APR) gives you a better idea of the total cost of your loan, but keep in mind that penalty fees for things like early or late repayments usually aren’t included in the APR. If you think that you’ll be able to pay off your loan early, consider looking for a loan with no early repayment fees.
A personal loan calculator is a great tool to help you visualize how much your loan could cost. You can put in different values to compare costs and decide what loan amount and terms you can ultimately afford.
2. Lenders consider personal factors
A lender might find itself in hot water if it were to deny a loan application based on age alone — this would be a clear case of age discrimination. However, your life stage can often play a role in whether you’re approved or not, which means older or younger individuals may have a harder time finding a loan.
At the end of the day, lenders are primarily interested in the odds of being repaid in full. When a lender’s historic experience says that certain age groups can’t be trusted as readily as others to repay the loan, they may approve and decline applications accordingly.
It can be more difficult for an 18-year-old or a retiree to find a personal loan. You can’t suddenly change your age, but you can compensate by showing other indications of financial reliability, such as a low debt-to-income ratio and a high credit score.
3. Credit score vs credit history
What’s the difference between your credit score and credit history? They’re not quite the same thing and many lenders will consider both.
If you’re looking for a loan, you should probably know your credit score. This is a three-digit number that lenders use to get a snapshot of your financial strength.
For a more in depth look at your needs, lenders also consider your credit history. This is a detailed record of relevant transactions, including open credit accounts, recent inquiries, bankruptcies, defaults and more. Repairing an imperfect credit report can be more difficult than improving your credit score, but both are important.
4. Computer approvals
Sometimes your application might be declined by a “robot” without a human ever setting eyes on it. This is often more prevalent with online lenders, because it’s one of the ways they can offer fast approval, sometimes within the hour.
Banks and lenders often use their own algorithms to check loan applications, automatically sorting the low-risk applications from the high-risk applications to preapprove strong applicants. It can be a way of weeding out prospective borrowers who don’t meet the initial eligibility criteria. If you’re considering applying with a lender that offers preapproval, it’s often worth reviewing their eligibility requirements to avoid wasting time on applications that go nowhere. You’ll also save your credit score a few points by preventing unnecessary hard pulls by lenders.
When should I avoid a personal loan?
Personal loans can be useful when you’re looking to consolidate debt or pay for a big expense upfront, but that doesn’t mean they’re always the best idea. Consider avoiding a personal loan when:
- You’re making a large purchase. Some things are better saved up for. Events like weddings and large vacations can be costly, and many financial experts advise against borrowing money for something that has no resale value.
- You’re trying to rebuild your credit. While debt consolidation can be a good way of minimizing open accounts, this may not always be the best way to boost your credit score. Instead, make timely repayments on your accounts and negotiate your debt with your current creditors instead of opening a new account.
- You’re spending too much. It may seem like an obvious point, but don’t overlook it. Taking out a personal loan for discretionary spending can be a waste of money. Instead, a line of credit or a credit card with a low limit may be a cheaper way to handle everyday purchases.
Personal loans can take a variety of forms and can be used for almost anything, but that doesn’t mean you should go with the first lender you find. Compare your options before applying for a loan, so you can find the best terms and rates to cover whatever expense you need covered.
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