How Do Personal Loans Work?

how do personal loans work in Canada

Personal loans are taken out by individuals for any number of reasons. They’re usually taken out with banks or other finance companies for reasons other than buying a home or car. Personal loans may be used to pay off high interest credit card debt at a lower interest rate, for example. They can be put to any number of uses.

Step One Is the Credit Check

Any time you apply for a personal loan, the bank or other lending institution runs a credit check. Typically, this means finding out your FICO score (sometimes just called your “credit score“) to see what your history with paying back credit has been. The higher your score, the more responsibility you have shown in managing debt. Higher credit scores pay off financially too; they help you qualify for larger loans and more favorable interest rates.

Conversely, low credit scores correlate with higher interest rates, and make it less likely you’ll qualify for a loan in the first place. If you have not established any credit, getting a personal loan may be difficult. You can make things easier by establishing credit, perhaps by asking for a small loan, or obtaining a credit card and being conscientious about paying your bill every month.

How Your Interest Rate Is Determined

First of all, interest rates track with the prime interest rate, which is the rate at which banks lend to each other. If the prime rate goes up due to economic pressures, then rates on personal loans go up as well. If you have outstanding credit, you could pay an interest rate of 3 to 5% on your personal loan. If you have poor credit, you could easily pay interest rates comparable to those charged on credit cards. Banks charge different interest rates based on the risk they assume when they lend to you. The greater that risk, the higher the interest rate the lender will charge. People who have no credit history, yet qualify for a personal loan due to strong income, for example, may still be charged a high-interest rate until their credit history is more established.

Cosigners and Collateral

Credit Score Check
A cosigner with good credit can help you obtain a personal loan.

People with bad credit histories can sometimes still get a personal loan if they either find someone to cosign the loan with them, or if they have something of value they can put up as collateral. A cosigner is someone with good credit who promises to pay back the loan if you default on it, so he or she assumes some risk when cosigning a loan.

Collateral can be any number of things, from a plot of land the borrower owns to a boat, for example. The bank holds the title to the collateral until the borrower finishes paying back the loan. If the borrower defaults on the loan, the bank takes possession of the collateral to resell in order to recoup the loss on the loan.

Terms of Personal Loan Repayment

If you are approved for a personal loan, it’s essential that you review all your loan documents and make sure you understand the repayment terms of the loan. The repayment terms include the total number of payments, how often you must make them (usually monthly or bi-weekly), your interest rate, and how much you will have paid in interest once you finish paying off the loan. If there’s any repayment information you don’t understand, ask your lender to explain. It’s absolutely critical that you understand the repayment terms and can agree to them for the term of the loan.

Personal loans are simple and versatile. The process of taking out a personal loan generally takes a few days to a few weeks. They may not be ideal for every financial need, but they can be useful for making large purchases, or for consolidating and paying off high-interest debt.

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Smarter Loans is an online directory listing only the best, most reputable providers of personal and business loans in Canada.