What Is a Personal Loan?

Personal loans can be a straightforward solution when you need to borrow money. Whether you need to take care of unexpected expenses like a car repair, or cover a large purchase like buying a new kitchen appliance, personal loans can offer you the money you need.

However, there are a few things you should know before you decide to borrow. Understanding the ins and outs of personal loans and how they work can help you make the right decision.

What is a personal loan?

Typically, a personal loan offers borrowers an upfront lump sum of money, which you repay in smaller installments over time. There are many different types of personal loans, and some of them are designed to help take care of specific financial needs like emergency expenses, home improvement, or debt consolidation for high-interest loans. Generally, personal loans are a flexible option that can help you cover a wide range of expenses.

How do personal loans work?

When you apply for a personal loan, the lender will evaluate your creditworthiness to decide if you qualify for the loan and what the loan terms will be. Depending on the lender, this may be a hard or soft credit check. These details help the lender determine things such as:

Loan amount. While you can apply for a specific loan amount, it is up to the lender to decide how much they are willing to lend.

Loan terms. This can include the repayment terms, if you will have weekly, bi-weekly or monthly payments and how long you will be repaying the loan.

Annual percentage rate (APR). Your APR combines the interest rate and any associated fees, such as origination fees, to give you a clear cost of the loan over time. With a good credit score, you may be able to qualify for a loan with a lower interest rate. However, a bad credit score may make it difficult to qualify — or it could mean you’ll be paying a higher interest rate.

If your loan application is approved and you sign the loan agreement, the funds are typically deposited into your bank account in one lump sum. From there, you can use the money to cover your expenses as you see fit. You’ll then need to repay the loan according to the loan agreement. You can often repay early to pay off your loan faster and save on interest, however you should be aware that some lenders will charge a prepayment penalty. If you continue to make your payments on time and in full, the loan will be paid off at the end of the loan term.

Types of personal loans.

Here are a few of the common personal loan options available.

Personal installment loans

Personal installment loans are what most people think of when they hear the term “personal loan.” They give you an upfront lump sum of cash, usually at a fixed interest rate, that is repaid over time in a series of smaller installments.

Personal lines of credit

Unlike an installment loan, a personal line of credit is a form of revolving credit. This allows you to withdraw funds as needed, up to a set credit limit. You’ll typically only pay interest and fees on what you borrow. As you repay, your balance will go down and the funds will become available to borrow again. A line of credit is a flexible option that can be good for managing ongoing expenses.

Online loans

Online loans are loans offered by alternative online lenders, in other words, non-banks. They are generally known for having fast approval and funding times — meaning they can be a good choice to cover emergency expenses. Though many online loans are installment loans or lines of credit, you should research your chosen lender to make sure what they’re offering fits your needs.

No credit check loans

No credit check loans are loans that can be issued without a credit check. Instead of looking at your credit report, lenders rely on other financial data to determine your eligibility. Before applying for a no credit check loan, borrowers should be aware that they often come with high interest rates and fees.

Bad credit loans

Bad credit loans are loans designed for borrowers with poor credit history. Lenders may run an alternative credit check, or look at other financial data, to determine loan approval. Just like no credit check loans, bad credit loans can be a costly form of borrowing.

What is the difference between a secured and unsecured loan?

Unsecured loans

Unsecured personal loans are loans that don’t require collateral, meaning you don’t have to offer an item of value to secure the loan. Instead, the lender’s decision relies upon your financial situation and your overall creditworthiness.

Secured loans

Secured personal loans are loans that require collateral. Collateral can be things like cash in a savings account, money in a certificate of deposit (CD) account, your car or another item of value. In the case of a home equity loan, your home acts as collateral. These types of loans can come with better terms, but you should be aware that the lender can seize your assets if you fail to repay.

What are the benefits of personal loans?

Flexible use of funds. Funds from a personal loan can be used to cover a wide range of expenses — from home renovations to credit card debt consolidation. This flexibility allows you the freedom to manage your personal finances easily.

Access to a larger amount of money. Personal loans can often offer you access to more cash than other forms of borrowing such as a credit card cash advance. When you need to cover a major expense, a personal loan can be a good option.

Predictable payments. Many personal loans are structured as installment loans with fixed rates. This means you will know exactly how much your loan payments will be and how long it will take to pay off the loan. This can make it easier to budget and manage your debt.

When to take out a personal loan.

A personal loan can be a good way to borrow in certain situations. Here are a few common ways people use personal loans.

Consolidating debt. If you have high-interest debt, a personal loan can be used to consolidate it. This can help streamline your payments and lower your interest rate, saving you money.

Handling emergencies. Sometimes emergency expenses pop up and you may not have enough in your checking account or emergency fund to cover it. Personal loans can help you take care of these unexpected costs.

Covering large one-time expenses. If you have big expenses like paying for home renovations, a wedding, or buying a new appliance coming up, a personal loan can help get you the money you need now and allow you to pay it off over time.

How are interest rates on a personal loan determined?

Different lenders will determine terms and conditions like interest rates according to their own requirements. However, there are few key things that most lenders will look at:

Creditworthiness. Your creditworthiness can heavily impact the amount of interest you’re charged. A good credit score can help you qualify for lower interest rates. On the other hand, a poor credit history means you’ll likely have to deal with higher loan interest rates.

Loan type. The type of personal loan you apply for will also have a big impact on your interest rate. For example, secured loans will often have a lower interest rate than unsecured loans.

Loan terms. You may find that loans that have a shorter repayment period come with lower interest rates. However, a shorter term could mean that your payments will be bigger because you have less time to pay off the loan.

Will a personal loan affect my credit score?

Yes, a personal loan can affect your credit score both positively and negatively if your lender reports to the credit bureaus. Here are a couple ways it can impact your score.

Applying. A lender may run a hard credit check while determining loan approval. This can appear on your credit report and lower your score for a short period of time.

Payment history. If you make your payments on time and in full, it can help you boost your credit score. However, late or missed payments may damage your score.

How does a personal loan compare to a credit card?

Be sure to review any credit card agreement for rates, terms and potential fees before signing.

What do you need to qualify for a personal loan?

Lenders will have different eligibility requirements, however there are few things that most lenders will look for.

Proof of income. Most lenders will require you to show that you’re earning a stable income. This shows them that you have the funds coming in to repay the loan.

Active checking account. Most lenders will require you to have an active checking account before approving you for a loan.

Valid I.D. Lenders will need to see proof of your identity before they will issue you a loan.

Financial situation. While not every lender will run a hard credit check, most will still run either a soft credit check or an alternative credit check to determine your ability to repay the loan.

How to find a personal loan.

You can apply for a personal loan at financial institutions such as banks, credit unions and online lenders. Banks often provide a wide range of options, while credit unions may offer lower interest rates to their members. Online lenders are known for their convenience and quick application and funding times. Each option has its own advantages. Before borrowing, be sure to do your research to ensure the financial institution you’ve chosen is reputable.

Finding the right personal loan for you.

Personal loans can be a good option for handling emergencies, consolidating debt or making large purchases. By understanding how they work, the different types of loans available, and the factors that affect your loan terms, you can make an informed decision. So whether you choose an installment loan, a line of credit or another option, responsible borrowing can be a helpful tool to help you achieve your personal financial goals.

DISCLAIMER: This content is for informational purposes only and should not be considered financial, investment, tax or legal advice.