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How Do Personal Loans Work?
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A personal loan is a fixed-term loan that consumers can use for virtually any purpose. They may get marketed as home improvement loans, medical loans or debt consolidation loans, but they’re still a personal loan.
Banks, credit unions and online lenders may offer personal loans. With a fixed repayment period and potentially low annual percentage rates (APRs), you may pay less for a personal loan than you would with a credit card. However, you don’t have flexible payments or the ability to add more to the loan after taking it out.
How do personal loans work?
Personal loans allow you to borrow money for almost anything you want unless the loan specifies how you must use the funds. These loans are installment loans, which means you make a flat payment over a set period called the term. Unlike credit cards, you can only receive funds from a personal loan once, which is when you take out the loan.
Thankfully, personal loans typically offer fixed interest rates. You should have the same loan payment for the life of the loan. The benefit to this is the loan is paid in full once the loan term is over. You don’t have the option of making a smaller minimum payment, though. You have to pay the entire loan payment every month or you may default.
From a financial standpoint, a personal loan could help if it’s cheaper than your other borrowing alternatives. Only you can determine if a personal loan is a good or bad idea for your situation.
Types of personal loans
It may seem as if you have several types of personal loans to choose from, but some of that perceived choice is marketing. That said, two distinct varieties do exist.
Various names for personal loans
As you’re searching for personal loans, you may find lenders that advertise them under different names. In certain instances, the name of the loan matters. For example, some lenders will offer different personal loan terms based on the loan’s intended purpose or only offer personal loans for specific purposes. You may receive a lower interest rate and longer repayment period if you use the loan to make home improvements rather than to consolidate your debt. Common names for personal loans include:
|Different names for a personal loan|
|Adoption loan||Fertility or IVF loan||Moving loan|
|Boat loan||Home improvement loan||Swimming pool loan|
|Debt consolidation loan||Horse loan||Vacation loan|
|Emergency loan||Medical loan||Wedding loan|
Unsecured vs. secured personal loans
When shopping for a personal loan, you may come across two types of personal loan offers. Each type comes with its pros and cons depending on your goals and situation. In general, the personal loan offers you see can either be secured or unsecured.
Secured loans require collateral, or something of value you give a lender the right to claim if you don’t fulfill your loan agreement’s terms. These loans generally offer lower interest rates. Putting up collateral lowers the lender’s risk compared with unsecured loans since the lender has an asset they can repossess if you don’t make your payments. Here are some key differences between the two types:
|What it is||Pros||Cons|
|Unsecured personal loan||An installment loan that doesn’t require collateral|| |
|Secured personal loan||An installment loan that does require collateral|| |
Common personal loan qualifications
A lender wants to offer an interest rate low enough to win your business while earning them a profit at the same time. Unfortunately, some loans end up not being repaid. Lenders use data to assess the risk that you may default on the loan.
In particular, they look at a few key personal loan requirements to determine whether you may qualify for a personal loan offer from their institution. They include:
- Loan amount
- Loan purpose
- Credit score (ideally 640 or higher)
- Reliable repayment history
- Debt-to-income ratio (generally below 35%)
Based on these factors and other information in your application, the lender decides whether to approve or deny your personal loan application. If you get approved, the lender also assigns an interest rate to your loan.
How does interest work on a loan?
The interest rate determines the amount of interest you’ll pay on a loan. Personal loans usually have a fixed interest rate that doesn’t change for the duration of the loan term. While the interest rate doesn’t change, the dollar amount of interest you pay changes each month as you pay down the loan balance.
Interest rates on personal loans vary from borrower to borrower and are often based on a few factors, such as your credit score, use of the loan, income and outstanding debt. Generally, the riskier the lender views you as a borrower, the higher the interest rate may be.
To get a more accurate sense of what a personal loan will cost you, you’ll want to take a look at the annual percentage rate (APR). Like interest rates, APRs are expressed as a percentage. APRs also take fees into account, in addition to interest, to give you a better sense of the personal loan’s total cost. Using the APR makes comparing two personal loan offers a bit easier.
You may be wondering, what is the interest rate on a personal loan? Here’s some data to give you an idea.
|Credit Band||Credit Score||Average Best Offered APR|
|Very Good||720 to 759||12.95%|
|Good||680 to 719||17.54%|
|Fair||640 to 679||22.74%|
Source: LendingTree Personal Loans Offers Report, April 2021
Range of personal loan APRs
The best average APRs on personal loans range from 9.47% for borrowers with credit scores of 760 and above and 22.04% for people with scores between 640-679, as of March 2021.
Take a look at the example below to see how your APR affects your monthly payment and overall loan cost.
Calculating personal loan interest costs
|Loan 1||Loan 2||Loan 3|
|Repayment period||60 months||60 months||60 months|
Calculate your own loan costs
Calculating your estimated loan costs is straightforward if you use this calculator. Input estimates of the loan amount, interest rate and loan term to get an idea of your potential payment and total costs for taking out a personal loan.
How to take out a personal loan
- Review your credit score: Your three-digit credit score plays a big role in your ability to borrow money and score a favorable interest rate. The higher your score, the more likely lenders will offer you favorable rates due to the assumed lower risk you pose as a borrower. Check your credit score to know where you stand.
- Shop around and get prequalified: APRs can range widely from lender to lender, so you’ll want to shop around to explore your options. Most lenders allow you to see loan offers with a soft credit check through prequalification. This can help you see the types of loan terms you may qualify for. However, prequalification is not a guarantee that you’ll be approved when you submit a formal application.
- Compare loan offers: After prequalifying with a few lenders, compare your loan terms as well as each lender’s fees — generally, both interest rate and fees will be reflected in the APR. Once you’ve found a lender you’d like to apply with, it’s time to move forward.
- Gather supporting documents: Lenders may require you to submit additional documents when you apply for the loan. Start gathering materials like proof of income (such as copies of paycheck stubs), proof of debt (like mortgage statements) and bank account statements now so that you’re ready for the application.
- Formally apply: You’ll now submit a formal application with your lender of choice. Online personal loan applications usually require you to agree to a hard credit check. Follow the instructions on the application, and submit any documents the lender asks for.
- Await a loan decision: Lenders usually make decisions pretty quickly after receiving your complete application and pulling your credit report. You might even get an answer within hours. The amount of time it takes to receive the money will depend on the lender. Some offer same-day funding with an electronic deposit to your bank account.