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Why Choose a Personal Loan Over a Traditional Loan?

03/02/2015 09:23 pm ET | Updated May 02, 2015

By Jocelyn Baird, NextAdvisor.com

There comes a time in many people's lives when they need more money than they have. Sometimes a credit card can be a quick solution, but there are situations where credit cards just won't work, and taking out a loan looks like the smartest option. All loans are not created equal, and in recent years the personal loan has become a great option for people to use. However, you might be wondering just what makes a personal loan different from a traditional loan from your bank. After all, personal loans can seem similar -- especially considering many banks now offer them alongside more traditional options. There are some key differences, which are important to know when choosing the right loan for your needs.

What makes a personal loan personal?

A traditional loan typically requires that you put up some kind of collateral, such as your house or your vehicle, in order to receive the loan. This gives the lender something to repossess if you default on your loan payments. This type of loan is also known as a "secured" loan, and while it might come with low interest rates, it also comes at a high risk to your livelihood if you were to get behind on payments. By contrast, a personal loan usually does not require collateral -- this can be called "unsecured." You are given an interest rate based on your creditworthiness, and the lender uses that information to form a basis for how much money it feels you'll be able to pay back. Banks and services offering personal loans may look at a number of things -- from your credit scores and reports to your income -- to determine your ultimate interest rate and how much you can be approved to borrow. Another great benefit of a personal loan is that it is meant for personal use -- you could take a loan out for just about anything, whereas many traditional loans require you to use it for a specific purpose, such as paying for a new car.

How could a personal loan benefit me?

You get your money faster. Traditional loans are often bogged down with paperwork with forms that may require you to sign in person. Personal loans, on the other hand, often have a very brief application with a quick turnaround time. Some services, such as AvantCredit or Lightstream, promise funds within the next business day once you are approved and have provided an e-signature. Peer-to-peer lending services may take a little while longer, but the process usually takes no more than 14 days.

It's not always borrowing from the bank. Many people these days don't trust banks and want to have the ability to turn to alternative places to find their financial solutions. Peer-to-peer lending is a relatively new personal loan business that has begun to catch on across the country. Rather than borrow money from a bank or other financial institution, services like Lending Club and Prosper allow approved borrowers to create a loan listing, which is then advertised to investors who supply the funds until the total loan amount has been received. These investors are regular people or companies that wish to use the peer-to-peer lending service as an investment opportunity. The lending service itself usually takes a small percentage of the total amount received -- known as a closing fee -- before the funds are disbursed to the borrower's bank account.

Are there any downsides to a personal loan?

Interest could be high. If you don't have great credit, chances are, you might end up with a very high interest rate. Since lenders aren't taking collateral, they only have your credit history and income information to base their decision on. Someone with a poor-to-average credit history might not seem worth the gamble, and so a higher interest rate will be tacked on to ensure the lender gets his money's worth. However, one of the great benefits to a personal loan is that they are almost always a "fixed rate" -- meaning the interest rate you receive will not change throughout the duration of your loan. In other words, your first payment will usually be exactly the same as your last -- so you just need to make sure you can maintain your monthly payments.

Sometimes charge hidden fees. Unfortunately, not all personal loan services have the interests of their borrowers at heart. Some charge hidden fees, so it's a good idea to read through all of the fine print before you commit. Something to look out for is what's called a "prepayment fee." This is a fee charged if you decide to pay off your loan early, which some loan services tack on to try and recoup some of the money lost by not receiving your full interest over the long-term. Helpfully, we have reviewed many of the top personal loan services to let you know which offer the best rates -- and outline what fees are associated with your loan. Most of the top-rated services don't charge any fees, beyond the usual late or rejected payment fees.

To learn more about personal loans and see how they could benefit you, be sure to check out our personal loan review page."

This blog post originally appeared on NextAdvisor.com.

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