Choosing the Right Type of Personal Loan for You

There’s a variety of loans to choose from, and knowing your options has a lot to do with making some smart borrowing decisions. 

When you decide to take a loan, you might need to borrow for things like debt consolidation or financing a big ticket item.

Some might be thinking about options like debt consolidation, bills, emergency expenses or home improvements for a loan. 

Each type of loan has its benefits and disadvantages, and choosing the right option depends on your needs and what you might qualify for. 

The main types of personal loan options are:

• Unsecured Personal Loans
• Secured Personal Loans
• Debt Consolidation Loans
• Personal Line of Credit (LOC) 

Personal Loan Types

Before we get into choosing the right type of loans, we need to start with the types of personal loans available. Each type of personal loan is slightly different for their terms and can use a small explanation. A personal loan is usually obtained through online lenders and financial institutions.

The following provides an overview of secured vs unsecured loans with some examples.

Unsecured Personal Loans

This type of loan does not require collateral and is sometimes known as a signature loan. These loans offer fixed interest rates with fix monthly payment amounts. Depending on the lender, the term will vary, but it is often from 1 – 4 years on average. Since this type of loan is a bit riskier for the lender the interest rates tend to be higher. 

Personal Loans – this type requires a good to excellent credit score to be eligible and provides the best option for interest rates. It also allows those that qualify to borrow a larger amount. These can have an interest rate of near 5% and amounts up to $50,000 for those that qualify.

Installment Loans – this is a common option for those that have fair to good credit that many qualify for. This type of loan can have interest rates that are upwards from 10% to 46% APR and loan amounts from $1,000 to $10,000 on average. 

Payday Loans – for those with bad credit that are unable to get approved from other lenders this type of loan is the most expensive borrowing option. It is advised that if you have other borrowing options that you make use of those and this type of loan is a last resort option.

Secured Personal Loans

A secured personal loan involves collateral, making it ‘secured’ by the asset such as property or a vehicle. Rates, fees and terms can vary considerably for this type of loan. Eligibility depends on similar circumstances with most secured or unsecured loans. Primarily the rates and terms you may receive depend on your income, credit history and credit score. A secured personal loan is also typically found through  online lenders and financial institutions.

Auto Loans – this type of loan is for those buying a new or used vehicle and require financing need a car loan. Those that trade in their vehicle can lower the cost of the loan, depending what their trade in is worth, the type of vehicle they look to finance, and repayment terms they choose. 

Home Loans – this type of loan is also known as a mortgage. Almost a third of Canadians have a home loan. This type of loan has the option of fixed or variable rates. A home loan usually requires including a down payment and has certain requirements even when collateral is involved. 

Line of Credit

Secured lines of credit (LOC) are like secured personal loans and come with lower interest rates as they are secured by collateral such as a home. An unsecured line of credit such as a credit card comes with higher interest rates since there is no collateral and of greater risk to the lender. If you choose to only make the minimum payments, an LOC can be a costly way to borrow like a credit card.

RELATED: Personal Loans vs Credit Cards – Which is Better?

Choosing a Loan

When trying to decide what type of loan might be the right borrowing option, it isn’t always about which option you might choose, but what you qualify for. This is mostly depends on your income, credit score, credit history, and the terms requested. 

Avoid borrowing more than you need to. The cost of borrowing suggests you should only apply for what is necessary. Some might have a large purchase or debt that they are borrowing for, and then consider that they should ask for more since requesting a loan already.

It’s said that you don’t choose a loan, it chooses you. In many ways, this is correct. Those with bad credit don’t qualify for the favourable rates of a personal loan.

With a line of credit you have the funds at your disposal when approved, and only pay interest on what you use.

RELATED: Personal Loans vs Home Equity Loans 

The first thing to consider is how much you need to borrow, and whether a loan is the right option. In some situations you might find a line of credit or home equity loan is more suitable, especially if planning to remodel or do some home renovations.

RELATED: Home Renovation Loans and Planning for a Remodel

Consumer Debt

The average consumer debt (excluding mortgages) is around $21,000, which would include auto loans and credit cards. Typical household debt including mortgages in Canada is about $75,000 and the average credit card debt is about $2,400. Using a debt consolidation loan where the interest rate is lower than the debt you’re looking to pay off can help to get rid of debt and save money at the same time.

RELATED: How to Choose the Right Debt Consolidation Loan 

In recent years the average debt-to-income (DTI) ratio has sky-rocketed to 136% in 2023. In the third quarter of 2022 it had reached an all time high of 183%. Comparatively, the average DTI for Canadians in the first quarter of 1990 was about 86%. 

When applying for a loan, lenders will look at your income, outstanding debt, and whether you can afford the loan amount requested. In addition to a poor credit score and/or history, having multiple loans at present can impact your odds of approval.

RELATED: What Credit Score Do You Need for an Online Loan 

As you explore the possibilities of borrowing and the options available, consider how making improvements to your credit score can reduce your borrowing costs. If your need for a loan isn’t urgent and you are close to a credit ‘band’ that might allow you to get better rates, it can be worthwhile to put your plans on hold to improve your score. For example, if your credit score was 650 (average in Canada) and you focused on improving that to 670 or more, you might shave a few percentage points from your loan that could help you save.

If your need for a loan is not urgent and your credit score sits at a certain point, such as 690 for example. By improving your score by 20-30 points may save you a significant amount in interest payments.  

You might also want to look into what lenders don’t say and some potential loan myths to be aware of too. Educating yourself before you start looking is one of the best way to prepare when trying to determine the right loan for you.