Personal Loans: Unsecured Debt and Interest Rates
Calculate your exact monthly payments and total origination costs using our Personal Loan Calculator, or read on to understand the financial risks of unsecured debt.
If you want to remodel your kitchen, consolidate credit card debt, or pay for an unexpected medical bill, a personal loan is often the fastest way to get cash.
Unlike a mortgage (which takes weeks to close and requires a massive pile of paperwork), a personal loan can often be approved and deposited into your checking account within 24 hours. But that speed comes with a steep mathematical cost.
Secured vs. Unsecured Debt
To understand personal loans, you must understand the difference between secured and unsecured debt.
- Secured Debt: Mortgages and Auto Loans are secured debt. The bank holds a legal claim (a lien) to a physical asset (the house or the car). If you stop paying the loan, the bank minimizes its financial loss by foreclosing on the house or repossessing the car. Because the bank's risk is low, interest rates are low.
- Unsecured Debt: Personal Loans and Credit Cards are unsecured debt. They are backed by absolutely nothing except your written promise to pay. If you default on the loan, the bank cannot repossess your kitchen remodel or your medical procedure. Because the bank takes on massive risk, interest rates are incredibly high.
While an auto loan might have a 5% APR, a personal loan for a borrower with the exact same credit score might carry a 15% or 20% APR to compensate the bank for the risk.
The Origination Fee Trap
The biggest mistake borrowers make when calculating the cost of a personal loan is ignoring the Origination Fee.
Unlike credit cards, which usually have no upfront fees, almost all personal loans charge a one-time Origination Fee (usually between 1% and 8% of the total loan amount). The bank deducts this fee before they give you the money.
The Math Problem: You need exactly $10,000 to pay a contractor. You get approved for a $10,000 personal loan with a 5% Origination Fee. The bank deducts the $500 fee, and deposits only $9,500 into your checking account.
You do not have enough money to pay your contractor, but you are still legally obligated to pay the bank back the full $10,000, plus interest!
If you need exactly $10,000, you must mathematically calculate the origination fee backward, and borrow roughly $10,526 to ensure you actually receive $10,000 in cash.
When to Use a Personal Loan
Despite the high rates and fees, personal loans are mathematically superior to credit cards in specific situations.
If you have $15,000 in credit card debt spread across three cards with an average APR of 26%, the interest is compounding daily and destroying your wealth.
Taking out a $15,000 personal loan at a 12% APR to instantly pay off the credit cards is a brilliant mathematical move (called Debt Consolidation). You slash your interest rate in half, and you convert revolving, compounding debt into a fixed, amortized loan with a strict payoff date.
FAQ
Does a personal loan hurt my credit score? When you first apply for the loan, the bank will do a "Hard Inquiry" on your credit report, which drops your score by a few points temporarily. However, if you use a personal loan to consolidate maxed-out credit cards, your credit score will often jump up significantly within a few months because your "Credit Utilization Ratio" (how much of your available credit limit you are using) drops to zero!
Don't get caught short by hidden bank fees. Calculate your true loan cost and origination deductions instantly using the CalcUnit Personal Loan Calculator.