Personal loans on the rise, but are they right for you?
Priced near credit cards but paid like auto loans, they find a niche
By Susan Ladika
Some consumers are shying away from plastic and instead turning to personal loans and lines of credit to gain more control over their financial life -- perhaps using them to pay down credit card debt, pay their tax bills or finance a trip down the aisle.
At the beginning of each year, "we see demand increase" for the products, says Todd Denbo, a Wells Fargo senior vice president within the personal credit management group. "Consumers start the year fresh with their personal finances in mind."
Wells Fargo's Debt Pay Down Solution is particularly popular among consumers who want to consolidate their credit card debt into a fixed loan, which runs for a fixed amount of time at a fixed interest rate, Denbo says.
Demand for personal loans at Wells Fargo "has been on an upward slope since the recession really started," he says.
How personal loans work
Personal loans and lines of credit are unsecured, so there's no collateral such as a house or car required for approval, and in most cases they can be used for any purpose the borrower desires.
With a personal loan, a consumer borrows a set amount of money for a certain amount of time at a set interest rate and pays a fixed monthly payment.
A personal line of credit is similar to a home equity line of credit, and borrowers can tap into it as needed. The payment will vary based on the amount owed; the annual percentage rate may also vary with the borrower's credit rating.
The rate a consumer pays varies based on credit history and credit score, and may also be influenced by the borrower's relationship with a particular financial institution or purpose for using the money. Your income and assets may also be looked at.
Total value of market unknown
The total value of personal loans and lines of credit is hard to come by. Personal loans are made by a host of institutions, large and small, and the Federal Reserve's statistics lump them in with other types of lending, making it tough to measure separately. Along with banks and credit unions, social lending is gaining ground. With social or peer-to-peer lending, there's no traditional financial institution involved. Instead, individual borrowers are connected to individual investors through sites such as Lending Club and Prosper.com.
At credit unions, unsecured loans are broken down between credit cards and "all other unsecured loans," with personal loans accounting for the vast majority of those. In National Credit Union Association data, the total value of "all other unsecured loans" was $25.58 billion in December 2011. That's a slight uptick from $25.47 billion in December 2010.
Ben Rogers, research director at the Filene Research Institute, a think-tank backed by the credit union industry, says credit unions run up against stiff competition from banks for mortgages and auto loans, which are both secured.
In contrast, credit unions are "generally more willing to write personal loans," Rogers says.
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Demand isn't just coming from consumers who want to pay off credit card debt. As the economic downturn took hold, credit card companies cut many consumers' spending limits or canceled cards. And home equity loans and lines of credit are out of reach for many consumers whose homes are now underwater.
Average APR lower than credit cards
The lower interest rate on personal loans compared to a credit card can also be a draw. According to the Federal Reserve, the average rate on a 24-month personal loan from a bank in November 2011 was 10.52 percent, compared to 12.36 percent for a credit card.
That's a bigger gap than in 2007, when the average rate on a personal loan was 12.38 percent, while it was 13.30 percent on a credit card.
At Wells Fargo, the demand for personal loans reflects "the interest consumers have in cleaning up their balance sheet," Denbo says.
J.J. Montanaro, a certified financial planner with USAA, says the bank hasn't seen an increase in demand for personal loans, but the products can be appealing because unlike credit cards, they have "a true beginning and a true end." With set payments, it's easier to budget each month.
As most interest rates have declined overall, USAA has lowered its best annual percentage rate (APR) from 12 percent to 10.99 percent for a 12- to 48-month personal loan.
Michigan First Credit Union, located in the Detroit area, closed more than 8,000 unsecured personal loans last year, totaling about $20 million. That's a 6.5 percent increase over 2010, says Chris Maynard, vice president of lending.
He thinks the upsurge is fueled by the economy turning around. "Members feel better about their jobs."
They may not be able to tap into equity in their homes to replace a roof or buy a new washer and dryer, so "unsecured borrowing has become very common," Maynard says.
Examples of personal loans
At Michigan First, rates start at 8.99 percent, and although the credit union offers both personal loans and lines of credit, loans are far more popular. The average loan is $2,500, and typically runs for 24 months.
At Hope Federal Credit Union, based in Jackson, Miss., but with locations in four Southern states, the credit union has a different mission than most. As a community development credit union, its goal is to help low- and moderate-income members improve their financial situation.
Many are unbanked or underbanked, and unaware of the products financial institutions have available, says Scot Slay, vice president of marketing. The credit union also wants to steer members away from payday and predatory lenders.
Hope offers 24-month personal loans capped at $5,000 or 10 percent of a member's gross income, whichever is less.
One of Hope's key goals is to help members end the revolving debt cycle, says Sandra Patterson, vice president of consumer lending. Paying a lower interest rate with a personal loan frees up more money for consumers to pay off debt or set aside money in savings.
Members who come in with revolving debt are automatically offered the opportunity to apply for a personal loan, Patterson says.
"We do everything we can do to be counselors," Patterson says.
For those seeking a nontraditional solution, sites such as Lending Club and Prosper.com connect borrowers and investors.
We do everything we can do to be counselors.
-- Sandra Patterson
Hope Federal Credit Union
From its launch in June 2007 through February, the Lending Club has originated loans worth $500 million, and plans to issue $500 million more this year, says CEO Renaud Laplanche.
While borrowers aren't required to disclose what they want to use the money for, Laplanche says two-thirds of those who do tell say they want to pay off credit card debt, while the other third use it for home improvement projects such as a kitchen or bathroom remodeling or to put in a spa or swimming pool.
It's not unusual, he says, for a consumer to charge something to their credit card, and then take out a loan to pay the credit card off in full at the end of the month.
As of late February, a top-tier borrower could pay as little as 6.78 percent APR at Lending Club. Loans are for $1,000 to $35,000.
Offering such an option "really fits the mood of U.S. consumers right now," he says.
Investors decide which loans to put their money into, so someone with $10,000 invested might have $100 in 100 different loans, and can choose what kind of borrowers to fund. One investor might choose only those with a 780 credit score or higher, while another investor, with a higher risk tolerance, might invest in loans given to those with lower scores, Laplanche says.
It's crucial for a consumer who takes out a personal loan not to use it to run up more debt, Montanaro says. "It should not be a tool to allow people to live beyond their means."
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