What is a Personal Loan and How Does it Work?

What Is a Personal Loan?

A personal loan is money borrowed from a bank, credit union, or online lender that you pay back in fixed monthly payments, or installments, typically over two to seven years.

Though it’s usually best to dip into your savings or emergency fund to cover unexpected expenses, personal loans can be a good option for non-discretionary purposes, like debt consolidation.

Summary

  • Personal loans are loans that can cover a number of personal expenses.
  • You can find personal loans through banks, credit unions, and online lenders.
  • Personal loans can be secured, meaning you need collateral to borrow money, or unsecured, with no collateral needed.
  • Personal loans can vary greatly when it comes to their interest rates, fees, amounts, and repayment terms.

Overview of a Personal Loan

A personal loan allows you to borrow money to pay for personal expenses and then repay those funds over time. Personal loans are a type of installment debt that allows you to obtain a lump sum of funding. For example, you might use a personal loan to cover:

  • Moving expenses
  • Debt consolidation
  • Medical bills
  • Wedding expenses
  • Home renovations or repairs
  • Funeral costs
  • Vacation costs
  • Unexpected expenses

These loans are different from other installment loans such as student loans, car loans, and mortgage loans that are used to fund specific expenses (i.e., education, vehicle purchase, and home purchase).

Some personal loan lenders restrict the ways in which you can use a personal loan. For example, you may not be able to get a personal loan to pay for college tuition, fees, or other expenses.

A personal loan is also different from a personal line of credit. The latter is not a lump sum amount; instead, it works like a credit card. You have a credit line that you can spend money against and, as you do so, your available credit is reduced. You can then free up available credit by making a payment toward your credit line.

With a personal loan, there’s typically a fixed end date by which the loan will be paid off. A personal line of credit, on the other hand, may remain open and available to you indefinitely as long as your account remains in good standing with your lender.

A personal loan is money borrowed from a lender that you pay back in monthly installments.

How do personal loans work?

Personal loans are a type of installment loan. That means you borrow a fixed amount of money and pay it back with interest in monthly payments over the life of the loan which typically ranges from 12 to 84 months. Once you’ve paid your loan in full, your account is closed. If you need more money, you have to apply for a new loan.

Loan amounts vary from lender to lender but typically range from $1,500 to as much as $100,000. The amount you qualify for is based on your credit health (i.e., how confident creditors are that you’ll pay them back if they lend you money).

It’s important to think about why you need the money and then chooses the type of loan that’s most appropriate based on your current financial situation.

Types of Personal Loans

Common types of personal loans include unsecured, debt consolidation, and co-sign loans.

Most personal loans are unsecured with fixed payments. But there are other types of personal loans, including secured and variable-rate loans. The type of loan that works best for you depends on factors including your credit score and how much time you need to repay the loan.

Unsecured personal loans

This common type of personal loan isn’t backed by collateral, such as your home or car, making them riskier for lenders, which may charge a slightly higher annual percentage rate or APR. The APR is your total cost of borrowing and includes the interest rate and any fees.

Approval and the APR you receive on an unsecured personal loan are mainly based on your credit score. Rates typically range from 5% to 36%, and repayment terms range from one to seven years.

Secured personal loans

These loans are backed by collateral, which can be seized by the lender if you default on the loan. Examples of other secured loans include mortgages (secured by your house) and car loans (secured by your car title).

Some banks, credit unions, and online lenders offer secured personal loans, where you can borrow against your car, personal savings, or another asset. Rates are typically lower than unsecured loans, as these loans are considered less risky for lenders.

Fixed-rate loans

Most personal loans carry fixed rates, which means your rate and monthly payments (sometimes called installments) stay the same for the life of the loan.

Fixed-rate loans make sense if you want consistent payments each month and if you’re concerned about rising rates on long-term loans. Having a fixed rate makes it easier to budget, as you don’t have to worry about your payments changing.

Variable-rate loans

Interest rates on variable-rate loans are tied to a benchmark rate set by banks. Depending on how the benchmark rate fluctuates, the rate on your loan — as well as your monthly payments and total interest costs can rise or fall with these loans.

One benefit is variable-rate loans typically carry lower APRs than fixed-rate loans. They may also carry a cap that limits how much your rate can change over a specific period and over the life of the loan.

A variable-rate loan can make sense if your loan carries a short repayment term, as rates may rise but are unlikely to surge in the short term.

Debt consolidation loans

This type of personal loan rolls multiple debts into a single new loan. The loan should carry a lower APR than the rates on your existing debts to save on interest. Consolidating also simplifies your debt payments by combining all debts into one fixed, monthly payment.

Co-sign loans

This loan is for borrowers with thin or no credit histories who may not qualify for a loan on their own. A co-signer promises to repay the loan if the borrower doesn’t, and acts as a form of insurance for the lender.

Adding a co-signer who has strong credit can improve your chances of qualifying and may get you a lower rate and more favorable terms on a loan.

Personal line of credit

A personal line of credit is revolving credit, more similar to a credit card than a personal loan. Rather than getting a lump sum of cash, you get access to a credit line from which you can borrow on an as-needed basis. You pay interest only on what you borrow.

A personal line of credit works best when you need to borrow for ongoing expenses or emergencies, rather than a one-time expense.

Other types of loans

Payday loans

A payday loan is a type of unsecured loan, but it is typically repaid on the borrower’s next payday, rather than in installments over a period of time. Loan amounts tend to be a few hundred dollars or less.

Payday loans are short-term, high-interest, and risky loans. Most borrowers wind up taking out additional loans when they can’t repay the first, trapping them in a debt cycle. That means interest charges mount quickly, and loans with APRs in the triple digits are not uncommon.

Credit card cash advance

You can use your credit card to get a short-term cash loan from a bank or an ATM. It’s a convenient, but expensive way to get cash.

Interest rates tend to be higher than those for purchases, plus you’ll pay cash advance fees, which are often either a dollar amount (around $5 to $10), or as much as 5% of the amount borrowed.

Pawnshop loan

This is a secured personal loan. You borrow against an asset, such as jewelry or electronics, which you leave with the pawnshop. If you don’t repay the loan, the pawnshop can sell your asset.

Rates for pawnshop loans are very high and can run to over 200% APR. But they’re likely lower than rates on payday loans, and you avoid damaging your credit or being pursued by debt collectors if you don’t repay the loan; you just lose your property.

Where you can get a personal loan?

Banks are probably one of the first places that come to mind when you think of where to get a loan. But they’re not the only type of financial institution that offers personal loans.

Credit unions, consumer finance companies, online lenders, and peer-to-peer lenders also offer loans to people who qualify.

A quick tip: Many internet lenders have emerged in recent years. If you’re not sure whether a lender is legitimate, consider checking with the Consumer Financial Protection Bureau or Better Business Bureau.

Personal loans vs. other lending options

While personal loans can provide the cash you need for a variety of situations, they may not be your best choice. If you have good credit, you may qualify for a balance transfer credit card with a 0% introductory APR. If you can pay off the balance before the interest rate goes up, a credit card may be a better option.

Be aware: If you get a balance transfer card and can’t pay off your balance or make a late payment before the introductory rate expires, you may rack up hundreds or thousands of dollars in interest charges.

If you’re a homeowner, you might consider a home equity loan or line of credit, sometimes called HELs or HELOCs, respectively. These types of loans could provide the financing you need for larger loan amounts at low rates.

While HELs are generally installment loans, HELOCs are a type of revolving credit. But beware: Your house becomes the collateral for these types of accounts. If you default, your lender usually has the right to foreclose on your home as payment for the loan.

Impact on your credit scores

When you apply for a loan, the lender will pull your credit as part of the application process. This is known as a hard inquiry and will usually lower your credit scores by a few points.

Generally speaking, hard inquiries stay on your credit reports for about two years.

When you’re shopping around for the best rates, some lenders that you already have an account with will review your credit. This is known as a soft inquiry and doesn’t affect your credit scores.

Consider checking your rates with lenders that will do soft pulls, which won’t impact your scores.

Interest rates and other fees

Interest rates and fees can make a big difference in how much you pay over the life of a loan, and they vary widely from lender to lender. Here are some things to consider.

  • Interest rates: Rates typically range from around 5% to 36%, depending on the lender and your credit. In general, the better your credit, the lower your interest rate will be. And the longer your loan term, the more interest you’re likely to pay.
  • Origination fees: Some lenders charge a fee to cover the cost of processing the loan. Origination fees typically range from 1% to 6% of the loan amount.
  • Prepayment penalties: Some lenders charge a fee if you pay off your loan early because early repayment means that the lenders are missing out on some of the interest that they would have otherwise earned.

Before signing on the dotted line, consider adding up all the costs associated with the loan, not just the interest rate, to determine the total amount of money you’ll be responsible for repaying.