How a signature loan works

Because there’s no asset to back up the loan, a signature loan is generally harder to qualify for in comparison to a secured loan. Lenders are looking to protect themselves from borrowers who might default on their payments, so a strong credit score is a non-negotiable. This is also why signature loans generally come with higher interest rates; however, those rates are typically lower than on most credit cards.)

The application process itself isn’t quite as involved as applying for a secured loan. Once the funds are deposited into your bank account, a two- to five-year to repayment timeline is pretty standard.

Signature loans also have fixed interest rates, so they’ll never fluctuate. The same goes for your monthly payment — in other words, it’s an installment loan that you pay back every month. This is different from credit cards, which offer revolving lines of credit you can charge up and pay off as you go.

Who should consider a signature loan?

When you need money fast and don’t have sufficient cash reserves on hand, a signature loan is generally a cheaper alternative to racking up high-interest credit card debt — a serious wealth killer that can cripple your ability to save for other big-picture financial goals, like putting money away for retirement or saving for a down payment on a home.

“I’d look at [a signature loan] as a lender of last resort where you’re really stuck between a rock and a hard place,” said Haynes. “Your only options may be to take out a credit card that’s going to charge you a 20% to 25% APR, or a signature loan where you’ll hopefully get a more favorable interest rate in order to bridge the gap.”

Signature loans can also be a powerful tool for getting ahead of your debt once and for all. Let’s pretend you have $12,000 in debt spread across three different credit cards:

At this rate, you’ll cough up over $5,500 in interest alone — that’s on top of the $12,000 you already owed! But look what happens if you pay off all this debt using a three-year personal loan with a 10% APR.

This option actually reduces your monthly payment from $450 to $387. The kicker? You’ll pay $3,570 less in interest over the life of the loan!

“You can often get a lower interest rate, which means every monthly payment makes a bigger dent in your loan balance,” Justin Pritchard, a Colorado-based certified financial planner, told MagnifyMoney. “Plus, there’s an end date, whereas credit cards can drag on forever if you only pay the minimum.”

Pros and cons of a signature loan

A lot of moving parts come into play, but here are some general pros and cons to consider.

Pros

• Quick cash: When your car breaks down or your roof springs a leak, time is of the essence. Most people simply can’t sit around and wait until their tax return comes in or that work bonus hits their bank accounts to pay for the damage. Signature loans are fast and convenient, especially for those who don’t have any assets to use as collateral.
• Easy application process: Thanks to the internet, there are a number of online lenders who’ve majorly streamlined the application process. A few clicks on your laptop or smartphone is all it takes to generate personalized quotes in a matter of minutes. Even if you go to a brick-and-mortar bank or credit union, applying for an unsecured personal loan is a relatively pain-free process. Secured loans like mortgages and car loans, on the other hand, are way more in-depth and time-intensive.
• Ideal for consolidating high-interest debt: Debt with sky-high interest rates will keep you chained to your balances for longer, and charging you dearly for it. A signature loan can be a game changer that reduces your interest rate, and maybe even lowers your monthly payment. And since this strategy also significantly decreases your open credit card balances — which makes up 30% of your FICO Score — your credit score will also enjoy a nice little boost.

Cons

• Signature loans aren’t free: Lenders aren’t going to give you something for nothing — on top of the interest rate, some lenders tack on an origination fee to make the deal worth their while. Average origination fee rates currently range anywhere from 0% to 6%. Even so, if you’re in dire straits or staring down excessively high credit card rates, an origination fee may be worth it.
• You have to have really good credit: The stronger your credit, the better your interest rate. It’s not that signature loans are off the table otherwise — there are plenty of lenders willing to work with people who have less-than-perfect credit — but you can expect to pay more. Those with a score below 600 may be looking at APRs upwards of 35%.
• You might just be kicking the can down the road: If you don’t have healthy financial habits in place (sticking to a budget, avoiding high-interest debt, and routinely putting money into savings), a signature loan may be nothing more than a Band-Aid. “Consolidating or refinancing doesn’t eliminate debt — it just moves it somewhere else,” said Pritchard. “Until you address the cause of your debt, it’s likely to come back.”

How to qualify for a signature loan

If this type of loan is on your radar, be prepared for lenders to pick through the following:

• Your credit score: Pritchard warns that a low credit score creates a very real barrier to approval. “You can look into using a cosigner, which might be risky for the cosigner but works out for the borrower because if they don’t have the credit score on their own, they’re either not going to be approved, or it’ll be at a higher rate or a smaller amount.”
• Your credit history: Lenders will also pore over your credit history. Haynes says that a track record of late payments or delinquent accounts could very well come back to haunt you, even if your score has since rebounded. Your current debt load is critical, as well — the less available credit you have, the less likely you’ll be to get the best loan terms.
• Your employment and income: This is another biggie, because you’ll need to prove that you’re bringing in a reliable, steady stream of income. Remember: lenders have no asset here to repossess, so they want to make sure you’re in a position to repay this loan. “They’re wanting to make sure you’ve got the wiggle room in your monthly cash flow to be able to pay whatever the principal and interest amount is on a monthly basis,” said Haynes. “So they’re definitely going to look at your income very closely to determine if you can make it work or not.”

Think a signature loan sounds right for you? If so, it’s time to shop around and compare quotes so you can lock down the best deal. Here are the most common places to find lenders.

Online Lenders

MagnifyMoney’s personal loan marketplace is a great place to start. Simply punch in how much you’re seeking, along with your credit score and zip code, and you’ll have instant estimates to browse through.

Pros

• The convenience factor is tough to beat: Shopping around online has become more and more mobile-friendly. These days, you can browse through personalized rates on your smartphone without ever getting off the couch.
• There’s a lot of variety: You may come across traditional financial institutions, as well as peer-to-peer lenders. These platforms connect borrowers with individual investors interested in loaning out money. Finding the best deal requires shopping around and comparing quotes across the board — the internet certainly makes this task easier.

Cons

• There are some shifty lenders out there: The internet also has no shortage of scams, no matter what you’re shopping for. Predatory lending is a real threat, so be sure you’ve thoroughly vetted your lender before doling out your personal information.

Banks

Prefer to work out the lending details in person? You may also be able to find a personal loan at your local bank.

Pros

• You’re getting an in-person experience. “At a local bank or credit union, you may be able to talk to the person evaluating your loan application,” said Pritchard. “Instead of meeting automated approval criteria, you can explain your finances and your circumstances in a way that makes sense for the bank. If everything looks good, you’ve got a better chance of approval.”
• All your finances are in one place: If you choose to borrow from the same bank that has your checking and savings accounts, your finances will all be at one place. That could make it easier to keep a bird’s eye view on your money.

Cons

• Your options may be limited. Many online platforms generate a variety of personalized quotes that you can then sift through and compare. Going with a single bank means you’re only looking at its loan options, so shopping around becomes much more cumbersome.
• You’ll probably spend more: Going to your local bank branch instead of an online lender is kind of like going to the mall instead of ordering on Amazon. Online businesses don’t have rent to pay, so their overhead costs are much lower — and they tend to pass those savings on to customers, which is what makes them so competitive.
• It’s usually tougher to get approved: Big banks have more to lose, so their qualifying criteria for a signature loan is generally more rigorous than an online lender. Many big-name financial institutions require even higher credit scores to get approved. They’re also known for having lower caps on how much they’ll lend.

Credit unions

Local credit unions should also be on your radar. Here’s what to consider:

Pros

• They might have more reasonable rates. Credit unions are generally structured in a way that exempts them from having to pay state and federal taxes. As a result, you may be able to find a lower-rate loan than what’s being offered at large banks.

Cons

• You have to be a member. Every credit union has its own membership requirements, so be sure to check their website before taking the time to visit in person. Some, for example, may be sticklers regarding the type of job you have and your employment status; others may require you to pay a membership fee.
• Selection might be limited. Depending on where you live, it might be slim pickings where credit unions are concerned. Gathering personalized quotes and shopping around may prove difficult, especially if you don’t qualify for a membership.

How to compare signature loans

Once you’ve got some personalized quotes in hand, it’s time to do some comparison shopping to make sure you get the very best deal.

Annual percentage rate (APR): The APR provides a clearer snapshot of how much this signature loan is going to cost you. It goes deeper than just the interest rate, taking into account fees and other one-time costs. When comparing quotes for signature loans, plug the numbers into MagnifyMoney’s Personal Loan Repayment Calculator to see how much you’ll pay in interest over the life of the loan.

Term length: A longer loan term translates to a lower monthly payment, which could provide some much-needed breathing room in your budget, but proceed with caution.

“You may end up paying quite a bit more in interest if you opt for a longer term,” warned Pritchard. “A little bit more pain in your monthly payment will result in less total interest and a lower cost of whatever you’re paying for.”

A $5,000 personal loan with a five-year repayment period and an 8% interest rate will cost you $101.38 a month. If you compress that timeline to three years, your monthly payment will only go up by nearly $56, but you’ll pay $442 less in total interest.

Fees: Again, some signature loans throw in origination fees to the tune of 0% to 6% — but there are other fees to look out for, as well. When comparing different quotes, read the fine print to see if there are any prepayment penalties. If you choose to eventually accelerate your payments to pay it off ahead of schedule, will you be penalized for it?

Conclusion

Signature loans are ideal for people who are up against some sort of unexpected financial emergency and don’t have the cash savings to cover it. This type of financing can also be a powerful debt consolidation tool.

When it comes to getting approved, your credit history, employment, and income are crucial. Gathering personalized quotes is as easy as surfing the web or popping by your local bank or credit union. No matter which option you choose, be sure to shop around to make sure you’re getting the best deal possible.