A personal loan can be a valuable tool to consolidate multiple credit card balances into one manageable debt payment. These loans often carry a lower interest rate than most credit cards, so you could save a significant amount in interest over the long run.
But these loans also come with costs and risks. Without doing the proper homework, you could choose a personal loan that—instead of improving your debt situation—could make it worse. It’s critical to consider these five numbers first.
Your lender will consider your debt-to-income (DTI) ratio—which is calculated by totaling your monthly loan payments and dividing them by your monthly pretax income. This number is the go-to measurement lenders use to assess your ability to repay a loan. In general, lenders prefer DTIs below 40%; some allow DTIs up to 50%, but you’ll likely pay more in interest for that loan.
For instance, say you have a $1,200 mortgage payment, a $125 auto loan payment and $250 in credit card debts, your monthly debt totals $1,575. If your gross monthly income is $5,500, you have a DTI of almost 29% and would likely qualify for a personal loan. If your gross monthly income is instead $3,500, your DTI would be 45%—making it harder for you to qualify.
Interest is the cost of borrowing money and is expressed as a percentage. Personal loans often carry interest rates between 10% and 35.99%, depending on your credit score, DTI and the amount you borrow.
The interest rate is important because it determines how much extra you will pay over the life of the loan. For example, if the interest rate on a three-year, $35,000 loan is 13%, then you will pay $7,454 in interest over the loan’s life. If the interest rate is merely three percentage points higher at 16%, you’ll pay $9,298 in interest, or $1,844 more than the first loan.
Annual Percentage Rate (APR)
When it comes to borrowing costs, the interest rate isn’t the end of the story. Lenders don’t just charge you for borrowing; they also charge a fee for making the loan. The APR represents the total annualized cost of the interest rate and any additional fees such as origination fees, closing costs and service charges.
The APR better represents how much you’ll ultimately pay for borrowing money, allowing you to make accurate comparisons when considering multiple loans.
The time you have to repay the personal loan is the “term.” The longer the term, the more manageable the loan is because the monthly payments are smaller. For example, a $35,000 personal loan with a three-year term—or 36 months—at a 12% interest rate comes with a $1,163 monthly payment. That same loan with one-year term has a monthly payment of $3,110. Your term depends largely on how much you can afford to pay each month.
It’s important to note that a longer term also means paying more in interest over the life of the loan. In the earlier example, you will pay $6,850 in interest on the three-year loan compared with $2,316 on the one-year loan. The shorter loan saves you $4,534 in interest.
Your credit score is a critical number determining how much you will pay to borrow money. A lower score signals more risk for the lender, which drives up the interest rate. For instance, a borrower with excellent credit may get a 10% interest rate on a three-year, $35,000 loan, while a borrower with bad credit will get a 25% rate on the same loan. Over the life of the loan, the borrower with bad credit will pay $9,441 more in interest. Fortunately, credit scores are not static. If you have a relatively low score and, therefore, face heavy borrowing costs, consider taking the time to improve your score before seeking a personal loan by reducing your debts and paying every bill on time, every time.