In a NutshellTaking out a loan may help you consolidate debt or pay for a big-ticket item. Whether it’s a personal loan, home loan or other type of financing, knowing a few basic steps can help you prepare for the process.
Every year, millions of Americans take out loans to pay for their homes, cars, educations and more.
Getting a loan can be a great option when you don’t want to dip into your savings account or don’t have the cash on hand to cover a large expense.
But before you apply, it’s important to understand how a loan will fit into your finances. A few basic steps can help you navigate the process. It starts with checking your credit, considering whether you can afford the loan payment and comparing loan options.
- Check your credit
- Consider your budget
- Calculate the total interest
- Compare loan options
- Consider any collateral
1. Check your credit
Having a strong credit history is a win-win: It can improve your chances of getting approved for a loan and help you qualify for a lower annual percentage rate, or APR. You can check your free credit reports before applying to see if there are any errors or if there’s anything you can improve. For example, paying down credit card debt can help boost your credit scores by reducing your overall utilization rate.
You can check your Equifax® and TransUnion® scores on Credit Karma.
Some lenders let you apply to prequalify for a personal loan, which is a process that helps you determine your chances of loan approval. Prequalification results in a soft credit inquiry, which won’t hurt your credit scores. But if you decide to officially apply for the loan, the lender will perform a hard credit check, which can lower your credit scores by a few points.
If your credit isn’t great and you don’t prequalify, then it may be worth it to hit the pause button on the loan application while you improve your credit. And take note: Even if you prequalify for a loan, it doesn’t mean you’ll be approved. If you are approved for a loan, your final terms may change if you officially apply.
2. Consider your budget
Setting up a budget gives you an idea of how much money you earn every month, where it’s going and whether you can afford to take on an additional expense. Here’s how to figure out whether the loan payment fits into your budget.
- Write out your regular expenses, including groceries, gas and all of your monthly bills. Add these expenses together.
- Calculate the income you earn each month after taxes.
- Subtract your monthly expenses from your monthly earnings.
- See how much is left. Is it enough to cover the loan payment on a monthly basis?
The key to successful budgeting is being realistic. If the loan payment barely fits within your budget, then you might not be able to afford it. You could wind up missing payments down the road, which could lead to penalty fees and damaged credit history. Consider borrowing less money, requesting a longer loan term or finding a different way to pay for your expense.
3. Calculate the total interest
Knowing your credit scores and the amount you want to borrow can help you determine the interest rate you might receive on a loan.
Interest influences how much a loan will cost over time. You can use a loan calculator to figure out the overall cost of a loan. Loans with longer terms usually have lower loan payments, but you may pay more in interest over time compared to a short-term loan.
For example, say you take out a $15,000 auto loan with a 3.5% interest rate. With a three-year loan term, monthly payments would be $440 and you’d pay $823 total in interest over the life of the loan. By stretching out the same loan over six years, the monthly payment would dip to $231 — but you’d end up paying double the interest.
4. Compare loan options
Getting prequalified with multiple lenders can help you compare your loan options and find the best deal for your situation. Compare loan amounts, terms, interest rates and any fees, such as origination fees and prepayment penalties.
If you don’t meet one lender’s requirements, then you can shop around to see if you can find another lender who will consider you for a loan.
More on the prequalification process
A prequalification helps you see the likelihood of your being approved for a loan, but it also helps the financial institution gauge whether you’ll repay the loan as agreed. Loan prequalification applications will vary based on the type of loan and the lender. Here are some examples of what you may need to provide.
- Identification details, such as your name, date of birth, address and Social Security number
- Information about your employer, gross monthly income and bank account balances
- Information about your monthly debt obligations, such as rent, student loan payments and credit card balances
- Permission to perform a soft credit inquiry
If you prequalify and move forward with a full application, the lender will likely perform a hard credit inquiry.
5. Consider any collateral
Securing your loan with collateral could help you qualify for a loan and get lower interest rates, even if you don’t have great credit. Collateral is something of value that you pledge to secure the loan — and the lender may be able to take this property if you fail to repay the loan as agreed. For example, a car is usually the collateral that secures an auto loan, and a house typically secures a mortgage or home equity loan. Some credit cards and personal loans may also require collateral, depending on your credit.
Before you take out a loan, it’s important to consider what would happen if you lose your collateral. For example, if you fall behind on your auto loan payments and the lender repossessed the car, how would you get to work and handle necessities like grocery shopping?
Once you’ve checked your credit and calculated the loan details, make sure you’re also prepared for future financial mishaps. Beefing up your savings account — with about three to six months’ worth of expenses — can help you avoid missed payments on your loan if a financial emergency comes up. The next step is to officially apply for the loan and use the funds for what you need.
But if you’re not sure a loan is the right fit for you, then consider these alternatives.
- Applying for a 0% APR credit card. If you have good credit, you may be able to get a credit card with a 0% introductory interest rate on purchases for a certain time period. If you can repay the amount you charge within the intro period, this could help you save on interest costs.
- Saving up money. Consider holding off on the purchase and saving up money for it — then you won’t have to pay interest.
No matter which option you choose, it’s important to try to borrow only what you need, understand the costs involved and repay the loan on time. That way, you can stay on top of your finances.