Personal loans are debt resolution solutions offered by lenders to individual consumers. Unlike a mortgage or auto loan, these loans do not have to be used solely for a specific, defined purpose. Once you are approved, you have discretion over how you utilize the funds. Most personal loans are provided as a lump sum amount that you pay back in installments over a fixed loan term. However, they can also be in the form of revolving credit. A revolving loan enables the customer to borrow money up to a certain fixed limit. The principal can be repaid back and then borrowed again up to the limit, and interest is only paid on the amount borrowed.
Most loans are offered as unsecured personal loans, which means that the borrower does not have to put up personal assets as collateral.
When Should I Take Out a Personal Loan?
The interest rate on personal loans varies based on your credit score, central bank rates, your relationship with your bank, etc. A higher credit score usually translates to a low-interest rate. While you are not usually restricted from what you can use the personal loan for, there are a few scenarios when a personal loan can be a good idea and other situations where it might not be a good option.
In general, a personal loan could be a worthwhile option if:
You are using it to pay off other debts that have a higher rate of interest
You are using it to make a purchase that will generate future returns
You need to fund an emergency expenditure that you cannot afford to pay outright from your savings, and can comfortably make principal and interest repayments in the future with your existing income
Scenario 1 is called debt consolidation. In debt consolidation, the lender lends the borrower a lump sum of money equal to the amount of outstanding debt they currently have. The borrower uses these funds to pay off more expensive debts and then pays back the lender over time. Debt consolidation is a good tool, particularly for credit card debt (which can incur annual interest rates as high as 23%).
In Scenario 2, the personal loan may be more favourable for a large purchase rather than using your credit card. One instance of a purchase that can generate future returns is a home renovation. By using a personal loan, you can increase the value of your property and pay relatively lower interest costs than what you would pay if you used a credit card.
Lastly, in Scenario 3, life can throw unexpected situations at you that require immediate funds. For these emergency expenses, you can borrow money from a lender. However, it is only worth doing so if you cannot afford to pay the expenses outright. It is also worth assessing what you are capable of paying each month after necessary expenses to ensure that you do not fall into a debt cycle.
Biggest Factors Influencing Loan Eligibility
If you are planning to apply for a loan in the near future, it is helpful to know the factors that lenders take into consideration when evaluating your application. If you have been denied a loan in the past, it is likely due to one or more of the following reasons.
Poor credit score and history
Your credit score is a 3-digit number up to a maximum of 900 calculated by a credit agency (Equifax or TransUnion). This credit score summarizes how responsible you have been with your credit in the past, while the credit report includes key aspects of your credit utilization, such as your current outstanding debts and repayment history on your debts. If you have a credit score lower than 650, you may not meet the minimum threshold required by certain lenders, such as chartered banks, that generally have tighter policies for loan approval.
In the absence of any collateral, your income is the primary consideration point for lenders to evaluate whether or not you can afford to pay back the loan you are seeking to borrow. To demonstrate your income, you need to provide your recent pay stubs or tax returns. This provides reassurance to the lender that you have stable employment credentials and the capacity to repay the principal and interest payments each month.
High debt-to-income ratio
Your debt-to-income ratio is calculated by dividing your total outstanding debts by your annual income. Each institution has different thresholds for the debt-to-income ratios that they accept from borrowers. If your ratio exceeds this threshold for the lender you are seeking an application from, you might be better served with an alternative lender.
In certain cases, you can opt to place your personal assets as security for the loan. In the absence of this security, lenders may look at other factors (such as income). If those factors do not meet lender criteria, your application may be rejected.
You have to be a minimum of 18 years of age to apply for a personal loan.
How to Increase Your Chances of Approval
There are a few steps you can take to improve your likelihood of approval.
Get all your documents ready beforehand
Almost all lenders will require the same baseline documents. These documents include your personal IDs (2 pieces), pay stubs and/or recent tax returns, proof of address, and employer verification (usually through a letter of employment). Have these ready to submit alongside your loan application.
Determine what type of loan you can reasonably afford
Use a personal loan calculator tool to assess the monthly principal and interest payments you will have to make. Based on your findings, determine if that is something you can reasonably afford to pay on your current income.
Pay down other debts
A debt-to-income score of 36% or under is usually considered ideal when lenders extend loans, although this can vary based on other factors. If your debt-to-income ratio is higher, it might be worthwhile to pay down other debts or wait until your income increases (provided that you can afford to do so) before you apply for a personal loan.
Build back your credit score
If your credit score is 650 or under, try to improve your score by making regular repayments on outstanding debts such as credit cards. Another way to increase your credit score is by increasing your credit limits on existing facilities.
While the aforementioned are all great ways to improve your loan eligibility, most steps require time for you to see the benefits. There may be instances where you find yourself faced with an emergency expenditure that requires immediate funds.
Magical Credit has worked extensively with borrowers without consistent income sources and/or suboptimal credit scores to offer online personal loans that meet their unique financial needs and constraints. In addition, if you are dealing with a difficult credit history, Magical Credit’s bad credit personal loans enable you to repair your credit score over time. Contact our team today to learn more.