What is a Personal Loan and How Do They Work?

A personal loan is money you borrow from a bank, credit union, or online lender that you repay in fixed monthly payments.

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A personal loan is a versatile financial tool you can use for many different purposes. Whether you want to settle existing debts, finance a major expense like a car or wedding, or do some home renovations, a personal loan can give you the funds to achieve your goal.

You can get a personal loan from traditional banking institutions, online lenders, or credit unions. These lenders will disburse the loan amount in one lump sum and require you to make regular payments until the debt gets paid off.

But, like with any financial product, personal loans have pros and cons. Before taking out a personal loan, consider how it will impact your credit and overall financial health.

Key Takeaways

  • Personal loans can be used for various expenses, such as car repairs, medical bills, home renovations, and weddings.
  • Personal loans can be secured or unsecured. Secured loans require collateral, while unsecured loans don’t require any.
  • The interest rates, fees, repayment terms, and amounts can vary between personal loans.

What is a Personal Loan?

personal loan is a flexible financial tool that gives you access to anywhere from $1,000 to $50,000 for different purposes. Lenders typically extend personal loans to eligible borrowers and expect the borrowed amount to get repaid in fixed monthly payments or installments over an agreed-upon period. The repayment structure usually includes the principal, interest, and other fees. The interest rates can range anywhere from 6% to 36%.

How a Personal Loan Works

Personal loans are different from installment loans, such as student loans, mortgages, or auto loans, which get used to fund specific expenses. Here are all the moving parts you should consider when looking at personal loans:

  • Interest rates: Personal loans have a fixed annual percentage rate (APR). The APR can vary depending on your creditworthiness, income, debt-to-income ratio (DTI), and other factors. The interest rate you get determines your cost of borrowing.
  • Monthly payments: Unlike credit cards, where your monthly payments may vary, personal loans come with fixed monthly payments you’ll make for the loan’s lifetime. If you agree to pay off your loan over a longer period, you can secure a lower monthly payment. But that also means you’ll need to pay more interest over time. Look for a monthly payment you can comfortably pay.
  • Repayment terms: Repayment terms for personal loans typically range from 1 to 7 years, though some lenders may offer terms up to 12 years for larger loans.
  • Origination fees: Depending on the lender, some may charge an origination fee for getting the loan, which can be as high as 10%.
  • Funding time: Lenders typically have fast approval or funding time for personal loans. If you are in a rush to access funds, look for lenders that deposit the same day after approval.
  • Customer Experience: Seek out lenders that make your life easier. Consider features like autopay, mobile apps, and flexible repayment options.

How Interest Rates Get Determined

The interest rate you get depends on several factors. One of the most important factors is your credit score. People with excellent credit scores tend to get the best terms and conditions on the market. Lenders also like to see that you have a steady and reliable income source to make monthly payments. They also prefer borrowers with a history of making on-time payments. How much debt you currently have can also play a role, as lenders may use that to gauge your ability to make loan payments. If you are in a lot of debt, you may not have the means to pay off new debt.

Types of Personal Loans

There are two main types of personal loans: secured and unsecured. Secured personal loans require collateral as a condition of borrowing money. For example, you may need to use your savings account, certificate of deposit (CD), or car to get a secured personal loan. If you default on the loan, the lender may keep your collateral to repay your debt. On the other hand, an unsecured personal loan does not require collateral to borrow funds.

Banks, credit unions, and lenders typically offer both secured and unsecured personal loans. However, because unsecured personal loans do not require collateral, they are considered riskier and may require you to pay higher interest rates.

Common Uses of Personal Loans

Personal loans are fairly versatile and flexible. Here are some of the common use cases:

Debt Consolidation

Debt consolidation involves combining several high-interest credit card balances or debt from other loans into one new account with a single monthly payment. While this move does not erase your debt, you may be able to secure a lower interest rate or monthly payment. A lower interest rate can save you money down the line and make it easier to pay off your debt.

Financing Big Events

If you have a major expense coming up, such as a wedding, vacation, or medical procedure, taking out a personal loan can help you cover some of the costs upfront. Once the event is over, you can repay the loan over time instead of having to finance everything yourself at the start.

Investing in Yourself

Some people take out personal loans for education purchases, such as workshops, seminars, and conferences. While you can’t use personal loans to cover college tuition fees directly, you may be able to use them to cover living expenses, books, rent, etc.

Home Improvement Projects

Although you can use a home equity loan or home equity line of credit (HELOC) for remodeling projects, these loans require you to use your home as collateral. In other words, if you default on your loan, the lender can take your home. That’s why many consumers turn to personal loans instead. With an unsecured personal loan, you can borrow money for home renovations without putting up your home as collateral.

Pay for Emergency Expenses

When an emergency strikes, such as a surprise medical bill or your car breaks down, you may not necessarily have the funds to foot the bill. Personal loans can help you react to the emergency immediately by giving you quick access to funds.

How to Get a Personal Loan

To get a personal loan, you need to complete an application, which includes sending in financial documents and verifying your identity. Most lenders have online personal loan applications, but some banks and credit unions may require you to apply in person at their branch.

But, before applying, check your credit reports at AnnualCreditReport.com. Having a higher credit score will increase your chances of getting approved for a personal loan with better terms and interest rates.

Once you’ve applied, the lender will pull a hard inquiry on your credit to gauge your creditworthiness and determine whether to approve or reject it. If approved, you’ll receive the loan terms and paperwork.

When that’s completed, the lender will disburse the funds through direct deposit into your bank account or via check. You can use the money for your intended purpose, and the first payment is typically due 30 days later. Ensure you have a monthly budget and a plan to pay off your debt. Don’t forget to set up autopay or payment reminders to make automatic payments to avoid paying late fees and protect your credit.

Common Mistakes When Using a Personal Loan

Here are a few common mistakes people make when they take out a personal loan:

  • Borrowing more than you can realistically afford: If you take out a personal loan and can’t make your payments, you may have to pay late fees, and your credit will take a hit. Before agreeing to a personal loan, use a personal loan repayment calculator to determine how much you can realistically afford to pay every month.
  • Getting stuck with high costs: Picking the first lender you find can cost you in the long run. Get quotes from different lenders to find the best deal for you and potentially save on interest costs. Compare the APRs, loan amounts, terms, and lender reputation.
  • Not factoring in all loan costs: Aside from interest costs, you may need to pay origination fees and other various fees. These can add up to a lot of additional costs, causing your debt to increase. Do the math to calculate how much the loan will cost you before committing to it.

3 Alternatives to Personal Loans

Credit Cards

credit card is a revolving line of credit that allows you to borrow funds as needed up to your credit limit. Depending on the credit card, you can earn rewards for your purchases that you can use for travel, shopping, statement credits, and more.

Credit cards are great for everyday purchases if you know how to manage your finances. I use my credit cards to pay for all my purchases to earn points. But I also pay off my balances on time and in full every month so I don’t have to pay interest. If you are bad with money, it’s easy to rack up a lot of credit card debt from the interest, annual fees, and late fees. Most credit cards have high interest rates ranging anywhere from 15 to 30% or more.

If you have a lot of existing debt, you can apply for a 0% APR credit card, which usually has a promotional period that lasts from 12 to 21 months. During that period, you will not get charged interest on your purchases, giving you time to pay off your debt. However, you’ll likely need good to excellent credit to qualify for these cards.

Cash-Out Refinance

Cash-out refinancing allows you to convert your equity in your house into cash by refinancing your mortgage. This method replaces your existing home mortgage with a bigger mortgage. You’ll receive the difference between the two loans in a lump sum payment. You can use the money for different purposes, such as home remodeling or consolidating high-interest debt.

Lenders typically allow you to borrow up to 80% of your home’s value, but the threshold can vary depending on your credit, the type of mortgage, and the type of property attached to the loan. A cash-out refinance can be a more affordable way to access cause because it comes with lower rates than most personal loans. But you’ll need to pay closing costs, such as an appraisal fee.

Home Equity Line of Credit (HELOC)

With a HELOC, the amount of credit you can draw depends on how much equity you have in your home, your credit score, employment history, and debt-to-income ratio (DTI). Typically, you can borrow up to 85% of your home value minus the amount owed (i.e. mortgages, HELOCs, and home equity loans).

Because your home gets used as collateral, HELOC interest rates are usually much lower than those of credit cards or personal loans and often comparable to mortgage rates. However, the rates are variable, meaning they fluctuate over time, though some lenders may offer a fixed interest rate option. Additionally, HELOCs are easily accessible and generally do not have origination fees.

The Bottom Line

If you need to borrow money and want stability, a personal loan may give you the capital infusion you need. But, before taking out a personal loan, you should weigh all your options to find the best possible loan for you.

We are not financial advisors. The content on this website and our YouTube videos are for educational purposes only and merely cite our own personal opinions. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know that all investments involve some form of risk and there is no guarantee that you will be successful in making, saving, or investing money; nor is there any guarantee that you won't experience any loss when investing. Always remember to make smart decisions and do your own research!

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