A primer on personal loans

Personal loans often attract borrowers because of their flexibility. These loans can be used to finance a wide range of items, such as home improvement costs or medical bills. "A personal loan is basically an unsecured loan," says Jane Bryant Quinn, the New York City-based author of "Making the Most of Your Money Now" and AARP financial columnist. "Assuming you're getting it from a bank, the bank will likely want you to have a checking account or mortgage with the bank."

Because of their unsecured nature, personal loans differ from auto loans, which come with a lien against the vehicle, and mortgages, which are backed by the asset of the home, says Todd Nelson, business development officer with Lightstream, the San Diego-based online consumer lending division of SunTrust Bank.

"You're providing money to that borrower without collateral on the back," he says. "We see people using personal loans for home improvement projects, swimming pools, kitchen and bath remodeling, landscaping, roofing, patios, gazebos, fencing or anything needed around the home. They also use personal loans from Lightstream for cars, boats, motorcycles and RVs. They're used to finance medical and dental procedures, to adopt a child or buy a horse."

A typical personal loan involves receiving a lump sum of money from a bank, and repaying that loan with interest over time. The term generally ranges from 36 to 72 months, says Phillip R. Christenson, certified financial adviser with Plymouth, Minnesota-based Phillip James Financial.

Substitute for home equity?

Personal loans can be used as alternatives to home equity loans. The home loan market remains tough for borrowers, so some see a personal loan as a good option, says Nelson.

"That market still requires a lot of paperwork, and a lot of time, and it takes a long time to fill out all the forms a lender may require," Nelson reports. "With a Lightstream unsecured loan, they can fill out the application in minutes, and sometimes get a decision within an hour. If they're approved, people can fund their loan within the same day."

But the wisdom of taking a personal loan in place of a home equity loan depends on a number of factors -- the loans' interest rates chief among them.

A personal loan's interest rate is typically based on the borrower's credit worthiness, as well as the size of the loan and the repayment term, Christenson says.

"Personal loans usually have lower interest rates when compared with a credit card or payday loan, but higher rates when compared with a home equity loan," he says. "In general, lenders are willing to lend at a lower rate if they know there is a valuable asset like a house backing up the loan. If a borrower defaults on a personal loan, the bank cannot take the borrower's assets."

Nelson says, however, that his company's personal loan rates are competitive with home-equity products and typically about half of most credit card rates.

Effect on credit scores

Most lenders who offer personal loans report to the three credit bureaus, so personal loans do show up on credit reports, Nelson says. Any time a borrower uses credit and pays off that credit as agreed with the lender, the result will be a positive impact on his or her credit score, he adds.

"If you pay personal loans on time, they help your credit score," Quinn says. "It's not any different from any other loan. Some banks give you a slight discount on interest rates, if you make payments automatically from checking."

However, the opposite is also true when it comes to your credit score, Christenson says.

"Personal loans are directly tied to the borrower, so if you have a missed payment or default on your loan, it could hurt your credit dramatically," he says.

In short, while personal loans aren't right for every situation, their flexible and straightforward nature can make them the ideal choice for some.