What It Means
Generally speaking a personal loan refers to money that is borrowed from a financial institution, known in these situations as the lender, for personal (as opposed to business) use. Personal loans tend to be for relatively small amounts, especially when compared to larger, long-term loans, such as home loans (also known as mortgages). While personal loans are typically used to pay for one-time expenses (such as medical bills, home repairs, or a significant purchase), a borrower (the individual receiving the loan) is usually not required to disclose the specific purpose for the loan. Indeed many borrowers seek personal loans simply to have a large sum of cash, which they can spend at their discretion.
Most personal loans fall under the category of unsecured loans. The two basic types of loans are secured and unsecured. With secured loans the borrower is required to offer some form of collateral to the lender in exchange for the loan. The term collateral refers to a piece of property or another asset belonging to the borrower, such as a car or a home, which is offered as a guarantee that the borrower will repay the loan. If the borrower goes into default (in other words fails to repay the loan or to keep to the terms of the loan agreement) then the lender is legally entitled to take possession of the collateral. Unsecured loans, on the other hand, do not require the borrower to put up collateral.
Because most personal loans are unsecured, they are often accompanied by a higher interest rate (a percentage of the money borrowed, calculated on an annual basis, which accrues over the life of the loan) than with secured loans. All loan payments consist of two parts: the interest and the principal (the amount of money borrowed, not including interest). As a guarantee that he or she will repay a personal loan, a borrower will often sign a document, known as a promissory note, pledging to repay the loan. For this reason personal loans are sometimes referred to as signature loans. Other common terms for personal loans are character loans (because they are based on the personal reputation, as well as credit rating, of the borrower) and good-faith loans.
When Did It Begin
Personal loans have probably existed since the earliest commercial transactions. In ancient civilizations in Greece, Rome, and the Middle East, lending at interest was a common practice. Lenders frequently set up tables in a central marketplace, where they offered loans to qualified customers at a set interest rate.
In the United States during the nineteenth and early twentieth centuries, unsecured loans were generally difficult for the average consumer to obtain. Traditionally banks only issued personal loans to select customers, who had a proven record of paying their debts. For the majority of individuals, however, these loans were unavailable. Most people seeking personal loans were forced to go to loan sharks. Loan sharks lend money to unproven customers at extremely high (and often illegal) interest rates.
In the early 1900s lending practices in the United States began to change dramatically. One of the pioneers of the modern personal loan industry was a Virginia lawyer named Arthur J. Morris (1881–1973), who founded his first bank in 1910 with the aim of extending credit to lower- and middle-income consumers. Known as the Morris Plan Bank, the bank was originally funded with $20,000, most of which was contributed by Morris himself. The bank’s earliest loans were designed to help the working poor purchase items that would improve their quality of life, such as homes or cars, or that would provide them with financial security in the event of an emergency.
By the early 1920s other banks throughout the United States began to implement the lending practices of the Morris Plan Bank. In 1920 a bank in Bridgeport, Connecticut, became the first financial institution to advertise personal loan products to lower income consumers. According to history professor Lendol G. Calder, author of Financing the American Dream: A Cultural History of Consumer Credit (Princeton University Press, 1999), only six banks in 1923 offered unsecured loans in the United States; by 1929 the number of banks offering personal loans had increased to 208. By 1931 Morris Plan banks had been established in more than 100 cities and were lending approximately $220 million annually in unsecured personal loans.
More Detailed Information
Applying for a personal loan is a relatively straightforward process. Applicants begin by completing a loan application. In filling out the application, prospective borrowers provide basic information about themselves, including name, social security number, date of birth, and contact information (generally street address, home phone number, work phone number, and e-mail address). Applicants will also be asked to provide employment information, such as the name and address of his or her employer and his or her job title and gross income (total amount of money earned before taxes). The loan application will also include a line for the desired loan amount. In some cases there might be a line where the applicant will be asked to describe the purpose of the loan (for example, the applicant might write “home repairs” or “consolidate debt”). Debt consolidation refers to the practice by which consumers use one form of credit (such as a personal loan or a credit card) to pay off several other existing debts, thereby consolidating several monthly payments into a single monthly payment. Debt consolidation is a common reason that borrowers apply for personal loans.
The bank or lending institution employee responsible for considering loan applications is known as a loan officer. In determining whether an applicant qualifies for a loan, a loan officer will consider several factors relating to the applicant’s overall financial situation. In addition to considering the applicant’s income, the loan officer will typically request a credit report (a detailed outline of the applicant’s credit history) from a credit bureau (an organization that sells consumer credit reports to lending institutions). Credit reports typically provide specific information concerning an individual’s current debts and credit history. A prospective borrower with a history of making debt payments on time will have a much greater chance of receiving a loan than a customer who has a history of late payments. One other important factor for loan officers considering a loan application is the applicant’s debt-to-income ratio (the amount of income a consumer uses to pay off debt every month). Debt-to-income ratios are calculated as a percentage. For example, if an individual earns $4,000 a month and makes annual payments of $800 a month on credit card debts, their debt-to-income ratio would be calculated at 20 percent. In general lenders will only offer an unsecured loan to an individual with a debt-to-income ratio of 35 percent or lower.
Interest rates for unsecured loans tend to be considerably higher (often double the percentage rate) than rates on secured loans. Personal loans usually are for smaller amounts and have maximum repayment schedules of between 48 and 60 months. The repayment schedule is generally determined according to the amount borrowed. For example, while a borrower might have 48 months to repay a $5,000 loan, he or she might only have 12 months to pay off a $500 loan.
With the rise of the Internet in the late 1990s, more and more potential borrowers have applied online for personal loans. Applicants can generally complete and submit their loan applications electronically and will often receive a response from a lending institution the same day. Many banks and other financial institutions have even created websites that allow existing customers to submit loan applications online, thereby saving them the trouble of visiting the bank to fill out an application.