Personal Loans: Everything You Need to Know Before Borrowing
Personal Loans: Everything You Need to Know Before Borrowing
Disclaimer: This article is for informational purposes only and should not be considered financial advice. Consult a qualified financial advisor before making financial decisions.
Personal loans are a popular way to borrow money for various needs, from consolidating debt to covering unexpected expenses. But before taking out a loan, it’s important to understand how they work, how they compare to other borrowing options, and how they impact your financial future.
1. Personal Loans vs. Line of Credit: What’s the Difference?
When borrowing money, you may come across both personal loans and lines of credit. While both provide access to funds, they function differently:
| Feature | Personal Loan | Line of Credit |
|---|---|---|
| Loan Type | Lump sum | Revolving credit |
| Repayment | Fixed monthly payments | Flexible payments |
| Interest Rate | Usually fixed | Usually variable |
| Best For | One-time expenses (e.g., car repairs, medical bills) | Ongoing or unpredictable expenses |
| Access to Funds | One-time disbursement | Can withdraw repeatedly (up to the limit) |
A personal loan is ideal for borrowers who need a fixed amount and prefer predictable payments, while a line of credit is more suitable for those who want flexibility and access to funds as needed.
2. What Credit Score Do You Need to Get Approved?
Your credit score plays a major role in determining whether you qualify for a personal loan and the interest rate you receive. Here’s a general breakdown:
| Credit Score Range | Loan Approval Chances | Typical Interest Rate |
|---|---|---|
| 800+ (Excellent) | Very High | Lowest rates (5%-10%) |
| 700-799 (Good) | High | Competitive rates (10%-15%) |
| 650-699 (Fair) | Moderate | Higher rates (15%-25%) |
| 600-649 (Poor) | Low | Very high rates (25%+) or denied |
| Below 600 (Bad) | Very Low | Unsecured loan unlikely |
Lenders also consider income, employment stability, and total debt service ratio (TDSR)—a key metric in Canada that determines how much of your income is spent on debt payments.
3. How Loan Term Affects Cash Flow
In Canada, most personal loans have a maximum term of 5 years, except for RRSP loans and car loans, which may have longer terms.
Shorter Terms (1-3 Years)
Higher monthly payments but less interest paid over time.
Longer Terms (4-5 Years)
Lower monthly payments but higher total interest cost.
Example Breakdown
- 3-year term: ~$323/month, total interest ~$1,630
- 5-year term: ~$212/month, total interest ~$2,748
Longer terms improve monthly cash flow but cost more in interest. If affordability is key, a longer term helps; if saving on interest is a priority, a shorter term is better.
4. Good Debt vs. Bad Debt
Not all debt is harmful—some can actually improve your financial future.
Good Debt
Helps build wealth or increase earning potential. Examples: Student loans, mortgage, business loans.
Bad Debt
Used for purchases that depreciate in value and offer no return. Examples: High-interest credit card debt, payday loans, excessive car loans.
A personal loan can be good or bad debt depending on its purpose. If used for debt consolidation (replacing high-interest credit cards with a lower-rate loan), it’s a smart financial move. If used for a vacation or luxury purchase, it may create unnecessary financial strain.
5. When to Pay Off a Loan Before Applying for a Mortgage
If you’re planning to buy a home, how you handle personal loans matters. In Canada, mortgage lenders use the Total Debt Service Ratio (TDSR) instead of the Debt-to-Income Ratio (DTI) used in the U.S.
What is TDSR?
TDSR is the percentage of your gross income that goes toward all debt payments, including mortgages, personal loans, credit cards, and car loans.
How to Improve Your Mortgage Eligibility
- Most Canadian lenders require a TDSR below 42% to approve a mortgage.
- A lower TDSR increases mortgage approval chances and may qualify you for better interest rates.
When to Pay Off Your Personal Loan Before a Mortgage Application
- If your TDSR is too high, paying off a personal loan lowers your monthly debt obligations.
- If your personal loan payment is higher than 3% of the remaining balance, paying it off improves mortgage eligibility.
- If you’re close to full repayment, clearing the balance can strengthen your mortgage approval chances.
Example Calculation
- A $10,000 loan with a $250 monthly payment shows as $250/month in your TDSR calculation.
- A $10,000 line of credit (not fully used) may only be counted as $300/month (3%).
A high fixed payment may hurt your mortgage qualification, even if the total balance is small. If possible, pay down the personal loan before applying for a home loan.
Final Thoughts: Should You Get a Personal Loan?
A personal loan can be a great financial tool when used wisely. If you need funds for a major expense, debt consolidation, or an investment in your future, it can be a smart option. However, it’s important to:
- Compare interest rates and loan terms.
- Understand how the loan affects your credit score and future borrowing potential.
- Plan for repayment in a way that supports your long-term financial goals.
By making informed borrowing decisions, you can leverage personal loans effectively without jeopardizing your financial health.
Thinking about getting a personal loan? Share your thoughts or questions in the comments!
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