When a Low-Interest Personal Loan May Be Worth Considering

A personal loan isn’t cheap just because it has an appealing advertised rate. A more useful comparison would be between a specific offer and the realistic alternatives available to the same borrower. An offer should be considered when it reduces total cost on an existing debt or if it finances an important expense with an affordable cost and does not place important spending at risk.

Most personal loans are closed-end installment loans. This means the borrower receives all the funds at the beginning and pays the loan back in fixed installments over a defined period. Different lenders or states may have loans with different rates, fees, and amounts that vary based on the payment structure and eligibility requirements. The final disclosures show the actual cost of the loan, not a phrase like “low interest” used for marketing.

Key takeaways

What “low interest” should mean

It’s not possible to define a universal interest rate for “low interest” personal loans. Each lender has their own pricing model. Factors that will affect personal loan rates include the loan amount, length of loan, borrower’s credit history and income, debt load, and underwriting. A competitively priced loan for one person may be expensive for someone else.

An interest rate is the cost of borrowing the principal for a defined period. An annual percentage rate (APR) describes the cost of credit on an annual basis, and can include other finance charges along with the interest. When an offer includes a cost of credit fee such as an origination fee, the difference between the interest rate and the APR is important.

APR is helpful for comparison, but it is limited in scope. Two offers may share an APR but have cost differences due to differing terms. A longer term may mean less scheduled payment but more total payment. Examine the financing charge and total payments in the loan disclosure, and see if the rate is fixed or if it can be changed.

When a lower-rate loan may be worth considering

The reason you require a loan is equally as important as the loan rate. It is understandable to take out a loan in cases where the loan is covering a specific issue, and the total cost is still a reasonable amount.

• Replacing more expensive debt: An example is if a borrower can consolidate their debts when their new loan’s total costs are less than the remaining costs of the debts they will pay off and won’t rebuild those balances.
• Refinancing an existing personal loan: An example is if the new loan will save the borrower on future interest even after factoring in origination and/or payoff fees and other associated costs, and the new loan does not extend the debt further than the old loan.
• Paying a necessary, planned expense: An example is that a fixed payment plan can be helpful if the planned expense is unavoidable, and less expensive payment alternatives are not feasible, and all payments are within the budget.
• Choosing predictability: An example could be a fixed-rate loan with a total cost that is reasonably competitive, and a value comparison indicates that a fixed loan is less costly than a debt with a variable interest rate.

Handling debt consolidation needs more attention. The Consumer Financial Protection Bureau says a lower monthly payment may result from a longer payment period and can cause a higher total cost. In its debt-consolidation guidance, the bureau also recommends resolving the spending problem or the income gap that caused the debt, as replacing the old balances can only postpone the problem.

When the advertised rate can be misleading

Certain advertised rates may be offered to only those who fulfill certain criteria. A lender can offer an alternative APR, amount, or term after an analysis of the application. Review the complete agreement and do not presume that a prequalified rate is a certainty.

• A fee reduces the cash received. If an origination fee is deducted before disbursement, the borrower receives an amount less than the stated loan amount.
• A long-term loan hides costs behind smaller monthly payments. Paying less each month is not a true savings if the total of the payments increases significantly.
• The agreement is subject to change. If the agreement is a variable rate, determine the index, margin, frequency, and maximum limits of adjustments.
• Optional products add expense. Credit/disability insurance and other add-on products should be evaluated as separate products and not as part of the loan.
• Collateral creates a separate risk. A secured offer may have different pricing; however, missed payments may put the pledged asset at risk. The contract controls the risks.

The CFPB includes charges related to origination, documentation, lateness, and certain types of insurance in its review of costs related to personal installment loans. In its review of fees related to personal loans, the CFPB recommends that the borrower review the lender’s disclosure and loan documents before accepting the offer. Borrowers considering providing collateral should also compare the pros and cons of secured vs. unsecured personal loans.

How to compare offers on equal terms

When comparing offers, reliability is highest when a lender provides a loan of the same amount and of the same term. An offer can appear to be affordable with a smaller loan, or a much longer term, when compared, but may not satisfy the same need.

1. Set the amount that is actually needed. If a fee is being deducted from the proceeds, confirm that the final amount is adequate.
2. Terms should be matched as closely as possible. Compare the same repayment period before evaluating whether a different term provides a better outcome.
3. Document the APR and type of interest rate and make a distinction if the rate is fixed and/or variable and if the quoted APR is conditional.
4. Be sure to list every charge. Note all charges, including charges for loan origination, loan documentation, late payments, returned payments, and prepayments, as applicable.
5. Compare the total dollar amount paid. Use the finance charge and the total of the payments as disclosed instead of estimating using the monthly payment amount.
6. Confirm the timing and penalties. Review the first payment due date, payment frequency, and terms of the grace period, penalties for a late payment, and loan payment in full terms.
7. Review the final agreement prior to execution. Confirm that the lender name, amount, APR, payment schedule, and fees correspond to the offer being evaluated.

A calculator can help with testing different amounts, rates, and terms, but its output is only an estimate unless it includes the actual fees and payment rules of the offer. The results of the loan calculator help the most as a preliminary step before looking at the disclosures of the lender.

How credit and prequalification affect the comparison

Not all lenders have the same pricing or approval models. Offers can vary based on credit reports and scores, but can equally vary based on income, debts, job status, and the borrower’s ability to repay assessment. Those considering loans with bad credit should be the most wary when thinking that receiving approval means good pricing models and that they can afford the loan.

Some lenders permit a borrower to use a soft credit inquiry to gauge possible terms, compared to a formal application which could result in a hard inquiry. The process differs among lenders, so the borrower should verify both the type and timing of the inquiry. The CFPB observes that lenders employ hard inquiries for a new loan application, whereas some account reviews and pre-screening use soft inquiries. Prequalification and preapproval are not final decisions, and verified amounts or rates are subject to changes.

When comparing initial offers, provide the same amount requested and give the same accurate answers each time. Inconsistent answers about income, housing cost, or the purpose of the loan will not help to determine if one lender is really the least expensive.

Test affordability before focusing on savings

A lower APR does not make a payment affordable. Before accepting an offer, test whether the full payment schedule works in a typical month as well as a bad month. Missing payments can cause a fee, damage your credit if the delinquency is reported, cause collection activity, and risk collateral in a secured loan.

• Use your after-tax earnings instead of your full gross income.
• Subtract your living expenses, things like housing, food, transportation, and payments you must make.
• Leave room for costs that are less frequent, like medical payments, repairs, or other expenses that aren’t paid on a regular basis.
• Leave a cushion instead of using up every dollar left over for new payments.
• See what the agreement allows if your income goes down or if a debt payment will be made late.

If the loan can only be paid if nothing goes wrong, it is likely the payment is unaffordable. Borrowing less, delaying the purchase, checking with the creditor for hardship options, getting in touch with a nonprofit credit counselor, or not taking a new loan are some safer options.

Protect personal information and recognize loan scams.

Before submitting any banking or personal information, be sure to confirm the lender or service. Review their privacy policies, and confirm they use a secure connection. Never send sensitive information after an unsolicited text, email, or call.

A legitimate low-interest loan will not include a promise of guaranteed approval. The Federal Trade Commission comments on the tendency of scammers to solicit payment during the loan offer for “processing,” “insurance,” or even for the paperwork. Their guidance on advance-fee loans encourages borrowers to check if the lender is licensed in the state and not to pay for a promise of credit. A genuine fee stated in a loan agreement is quite different from paying a stranger in advance to guarantee loan approval.

Questions to ask before accepting

• What amount of cash will be available after all fees have been deducted?
• What is the APR? What is the finance charge? What is the total of payments? What is the number of payments? What are the due dates?
• Is the entire term interest rate fixed?
• Are any of the insurance products or add-ons required?
• Is a fee charged for paying off the loan early?
• What is the consequence of a late payment, a missed payment, or a payment that is returned?
• What collateral is pledged for a secured loan and when will the lender access this collateral?

Frequently asked questions

Does the lowest APR always produce the lowest total cost?

No. APR gives a sense of the cost of credit, but to understand what a borrower will pay, the loan amount, the repayment term, how fees are charged, and when payments are made all matter. Compare like offers for the same need and evaluate the finance charge and the total of payments.

Can a lower monthly payment make a loan more expensive?

Yes. An extension of the term can shrink each payment, but lead to an increase in the number of payments and the total cost. A smaller payment will only be useful if the extended schedule and increased cost are still tolerable.

Is prequalification a guaranteed offer?

No. Prequalifying generally means you’re doing a preliminary assessment based on very little or unverified information. After checking documents, credit information, income, debt, and what other eligibility factors there are, a lender may change the terms or even deny the application.

Should someone use a low-interest loan to consolidate credit cards?

It might be logical if the new loan is cheaper, the payments are manageable, and the borrower intends not to incur new credit card debt. If the loan merely prolongs the payment schedule or increases credit card limits for spending, the borrower may end up with more debt as a result of consolidation.

Bottom line

A personal loan with low-interest rates can be beneficial to the borrower when they budget for an affordable loan payment, see actual savings on the final offer, and know the terms and the repercussions of the agreement. The decision should be based on clear disclosures and a comparison of costs. It should not be based on the advertised rate and approval message, or a low monthly payment.