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How do personal loans work?
Here's the process in 8 simple steps.
Personal loans are a relatively common financial need. If you’ve never borrowed one, it may seem a little complex. We break down the steps below so you know what to expect.
How do personal loans work?
Personal loans are similar to other types of loans: You borrow money from a lender to pay for any personal expenses, which you repay over a period of time with interest.
To take out a personal loan, you’ll need to fill out an application form with your personal and financial information and provide supporting documents.
Step 1: Compare personal loans
Finding the right personal loan is the first step of the process. Here are some loan features to consider.
Type of personal loan
- Secured personal loan. This is a loan backed by collateral, such as your home, car, investments, jewelry and more. It generally has lower interest rates than an unsecured loan because you reduce the risk for the lender.
- Unsecured personal loan. This is a loan without collateral. It tends to have higher interest rates than a secured loan.
Other features to consider
- 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 6 months and 5 years are available, but terms differ among providers.
- Interest rate. Is the rate fixed or variable? A variable rate means your interest rate will fluctuate with the markets, while a fixed rate means your rate will stay the same throughout the loan term. Is the rate competitive compared to other lenders offering similar products?
- Fees. Check for extra fees such as origination fees (admin fee to process your loan), penalties for repaying your loan early and late payment fees.
- Repayment amount. Once you know your loan amount, interest rate and term, you can use a loan repayment calculator to see how much the repayments will be and whether you can afford them.
- Repayment terms. Can you choose your payment schedule? Can you make extra repayments without penalties? Can you repay the loan early without penalty?
- Lender reputation. How does the lender treat its clients? Check reviews to see what others have to say about the lender.
Compare your personal loan options
Step 2: Eligibility
Lenders have 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 or monthly 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. 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 among lenders. Many lenders give you the option to apply online, at a branch or over the phone. You can expect lenders to ask for the following information:
- Name and contact information
- Address and number of years at your address
- How much you want to borrow and the purpose of the loan
- Employer, job title and income
- Existing debts
- Social Insurance Number (sometimes)
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: Pre-approval
Many lenders provide pre-approval. Giving pre-approval means the lender has lightly scanned your finances and wants to proceed with your application. It may even provide you with a quote at this point. However, the loan is not yet guaranteed because the lender still intends to complete a more in-depth review of your finances.
Some lenders give fast pre-approval, sometimes within minutes after you submit your application.
Step 5: Approval
If you want to proceed with the loan, the next step is official approval. At this point, the lender will ask for documents to verify the information you provided on your application, which can include:
- Government ID. You’ll need to provide your driver’s licence, passport or another form of government-issued identification.
- Proof of income. Depending on the lender, you may need to provide 3 to 6 months of pay stubs or bank account statements. If you’re self-employed, lenders may request tax returns from the last 2 years.
- Other financial documents. If you have other debts, such as loans or credit cards, you may need to provide statements from those accounts.
Online lenders usually take 1 to 2 business days to give approval, while banks and credit unions can take longer.
Step 6: Loan agreement and funding
Review the terms and conditions of the loan agreement, and sign if you’re comfortable with them. Once you sign and submit your agreements, the funds will be transferred to your bank account.
Step 7: 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 8: 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.
Watch out for these 3 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 for lenders 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.
Consider these 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 3-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.
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.
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.
Frequently asked questions
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Secured loans in Canada
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Compare lenders offering loans with no early repayment fees in our guide.
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Learn more about the interest rates and fees you’ll pay, and how they affect the cost of your personal loan.