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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.
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 loan||Secured personal loan|
No repossession risk
Loan funds can typically be used for any purpose
Usually comes with lower interest rates
Generally easier to get approved for
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
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 reasons
|Adoption||Fertility or IVF||Holiday expenses|
|Adoption||Fertility or IVF||Holiday expenses|
|Boat purchase||Home improvement||Swimming pool financing|
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:
- Loan amount requested
- Loan purpose
- Credit score (ideally 640 or higher)
- Reliable repayment history
- Debt-to-income ratio (generally below 35%)
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
- 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 range||Average APR|
|Less than 560||135.83%|
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 1||Loan 2||Loan 3|
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.
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.