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How Do Personal Loans Work?

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Personal loans are a common form of credit that can be used for anything from debt consolidation to covering medical expenses. But how do personal loans work?

Personal loans are fairly straightforward, but there are a lot of details worth paying attention to in order to make your application process as smooth as possible.

Read on to learn more about what a personal loan is, how it works and how to get one.

What is a personal loan?

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 these are all still 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, unlike a credit card, personal loans don’t have flexible payments or offer the ability to add more to the loan after approval.

How do personal loans work?

Personal loans allow you to borrow money for almost anything you want, unless the lender specifies how you must use the funds.

These loans are a form of installment loan, which means you make monthly  payments over a set period. Unlike credit cards, you receive personal loan funds in a lump sum when you take out the loan, and if you need more cash, you’ll have to apply for another loan.

Thankfully, personal loans typically offer fixed interest rates. You should have the same loan payment for the life of the loan.

The loan is paid in full once the loan term is over, but you won’t have the option to make a smaller minimum payment. You have to make the entire loan payment every month or you may default.

Are personal loans bad?

You may get the impression that a personal loan isn’t a good idea, but that isn’t always the case. A personal loan could change your credit score, but its exact impact depends on your credit profile.

The hard inquiry from applying for a loan could result in a slight, temporary decrease, but using the loan to pay off a maxed-out credit card could help your revolving credit utilization ratio, potentially giving your score a boost. If you make all of your loan payments on time, your credit score could benefit.

Types of personal loans

When shopping for a personal loan, you may come across two types of offers: secured or unsecured. Each type comes with its own pros and cons, and which is best for you will depend on your goals and situation.

Secured loans require collateral, or an asset of value the lender has the right to seize if you don’t fulfill your loan agreement’s terms. These loans generally offer lower interest rates because they present less risk to the lender.

Unsecured loans, however, are backed only by your promise to repay the debt. Therefore, lenders rely entirely on your creditworthiness, income level and amount of current debts when deciding whether you’re a good candidate. Because the risk is higher for the lender, APRs are also typically higher on unsecured loans.

Here are some key differences between the two types:

Unsecured personal loanSecured personal loan
Pros

  No repossession risk

  Loan funds can typically be used for any purpose

  Usually comes with lower interest rates

  Generally easier to get approved for

Cons

  No collateral often results in higher interest rates

  May be more difficult to get approved based on your credit, income and outstanding debt

  Must have collateral to put up for the loan

  Collateral can be repossessed

Should you choose an unsecured or secured loan?

Choosing between a secured and unsecured loan depends on your circumstances. If you don’t have any collateral to offer, an unsecured loan will likely be your only option. People with collateral may be able to secure a lower interest rate but add the risk of having that collateral repossessed if they default on the loan. Ultimately, you must decide if a secured loan’s lower interest rate is worth the risk of potential loss of your asset.

Personal loan reasons: Why they’re important

As you’re searching for personal loans, you may find that lenders sometimes advertise them under different names.

In certain instances, the name — or the purpose — of the loan matters. The purpose of your loan can determine your rates and even creditworthiness in the eyes of lenders.

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. Many lenders have prohibited uses of personal loans as well.

Personal loans are commonly used for:

Common personal loan requirements

Lenders want to offer an interest rate low enough to win your business but high enough to earn them a profit.

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 qualify for a personal loan offer from their institution. These include:

Based on these factors and the other information in your application, the lender then decides whether to approve or deny your personal loan application. If you are approved, the lender also assigns an interest rate to your loan.

How does interest work on a loan?

The annual percentage rate (APR) determines the amount of interest you’ll pay on your loan.

Like interest rates, APRs are expressed as a percentage. APRs also take fees into account to give you a better sense of your loan’s total cost.

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, including:

  • Your credit score
  • Loan purpose
  • Income
  • Amount of current debts

Generally, the riskier the lender views you as a borrower, the higher the interest rate may be.

You may be wondering, what is the interest rate on a personal loan?

Here’s some data on average APR by credit score to give you an idea of what you may be able to expect:

Credit score rangeAverage APR
720+9.81%
680-71916.01%
660-67923.54%
640-65928.93%
620-63935.98%
580-61954.17%
560-57985.24%
Less than 560135.83%

Source: LendingTree Personal Loan Statistics, June 2022

Calculating personal loan interest rates

The best average APRs on personal loans range from 9.81% for borrowers with credit scores of 720 and above and 28.93% for people with scores between 640-659, as of June 2022.

Take a look at the example below to see how your APR affects your monthly payment and overall loan cost. In this example, all three loans are for $10,000 and are repaid over 60 months. Notice the impact APR has on your total repayment cost.

Loan 1Loan 2Loan 3
APR9.8%16%23.5%
Monthly payment$211.49$243.18$284.78
Total repayment$12,689.26$14,590.83$17,087.09

Calculate your own loan costs

Calculate your estimated loan costs by using this personal loan 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 apply for 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 are to offer you favorable rates due to the assumed lower risk you pose as a borrower. Check your credit score to know where you stand, and if necessary, work on improving your score.

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 work 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 your personal loan will depend on the lender. Some offer same-day funding with an electronic deposit to your bank account.

Personal loan mistakes and how to avoid them

While the process of getting a personal loan is simple, you may make some common personal loan mistakes if you’re not aware of your options.

  Borrowing more than you need: Long before you apply for a personal loan, it’s important to evaluate your budget to see how much you can afford to borrow and pay every month. In particular, it’s important to ask yourself if you’ll have enough money to cover monthly payments even if you come across an unexpected emergency expense.

  Not comparing offers: If you accept the first offer you receive, you may be missing out on the opportunity to save yourself some money. Receiving multiple offers can help you analyze which lender can offer you the best rate, terms and perks.

  Overlooking fees: It’s easy to miss the information about fees if you don’t read through the fine print of your loan agreement. Personal loan lenders often charge origination fees and late fees, but there are many lenders that don’t charge fees at all.

Frequently asked questions

Personal loans can affect your credit score, as lenders typically run a hard-credit pull before officially offering you a loan. This can cause your credit score to dip by a few points, though the impact is temporary and your credit score can eventually go back up.

Most of the time, lenders deposit the funds for your personal loan directly into your checking account. If you’re borrowing the funds for debt consolidation, some lenders will send funds directly to your other creditors.

Many lenders offer personal loans for a wide range of purposes, including to cover medical bills, home improvement projects or major life events. However, that doesn’t mean you can use your personal loan for just anything. Many lenders have prohibited uses; many personal loan lenders don’t allow borrowers to use their funds toward college, investments or business expenses.

Personal loans offer many advantages, such as fixed loan payments, low interest rates (if you have good credit) and loan terms. This way, you’ll not only know what you’ll be paying each month, but you’ll know when your loan will be paid off.

Yes, there are many lenders who offer bad credit loans. Keep in mind that your APR is likely to be higher than the one offered to a borrower with a high credit score.

 

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