A personal loan is money from a lender that can be used for almost any purpose, including paying off debt, financing a major purchase like a car or boat, or paying for a big expense like a wedding or vacation.
Loans can be obtained from online lenders, local banks and credit unions, and the funds are provided in a lump sum. Once you receive the cash, you must make payments until the loan is fully repaid.
One of the biggest advantages of personal loans versus credit cards is that they come with fixed interest rates and repayment terms.
What is a personal loan?
A personal loan is money you borrow from a bank or other financial institution with a fixed repayment period and consistent monthly payments. Most personal loans are unsecured, so you don’t have to put up collateral to borrow money. Loan amounts vary widely, from about $1,000 to $50,000 or more, and interest rates typically range from 3 percent to 36 percent. Borrowers get one to seven years to repay the money.
This is how it works
If you’re looking to get a personal loan, you’ll need to complete an application and wait for approval — a process that can take anywhere from a few hours to days. Once you are approved, the lender disburses the money into your bank account and you use the funds for your purpose. You will start paying back immediately. Throughout the term of the loan, your lender will report your account activity to the credit bureaus. Making payments on time can help you build a positive credit history.
Here is an explanation of all the parts that make up a personal loan:
- Interest Rate: Personal loans charge borrowers a fixed APR or annual percentage rate on the loan amount (or principal). This APR can vary depending on credit eligibility, income and other factors. The personal loan interest rate determines how much interest the borrower pays over the life of the loan.
- Monthly payments: Personal loans come with a fixed monthly payment that you will make for the life of the loan, calculated by adding principal and interest. If you agree to pay off your loan over a longer period of time, you can usually secure a lower monthly payment.
- Repayment Timeline: The repayment timeline varies for personal loans, but customers can choose between one and seven years of repayment.
- Origination Fee: Some personal loans charge an initial origination fee on top of your loan principal amount. Although origination fees vary, it is common to see an origination fee of 6 percent of your loan amount.
How rates are determined
A personal loan APR determines how much interest you will pay over the life of the loan. Personal loans can come with a fixed rate, in which the APR remains constant for the life of the loan, or a variable rate, which can fluctuate over time. The APR includes the personal loan’s interest rate, fees, and other lender costs.
Lenders sometimes set a variable rate based on a well-known index rate, such as the prime rate (the interest rate at which banks and other financial institutions lend to each other). Lenders can limit the variable interest rate so that it doesn’t rise above a certain amount — even if the index rate rises. However, most personal loans come with a fixed APR, which means your monthly payments will be predictable.
Your APR is determined based on several factors, the most important of which is your credit score. If you have a good credit score, you may qualify for the lender’s lowest rates — the best rates typically go to people with credit scores over 700. Some additional factors that affect the APR you are offered include:
- Annual Income: Lenders like to see a steady and reliable source of income that can be used to make monthly payments. This can also lead to a more favorable APR.
- Payment history: People with a solid history of on-time payments generally qualify for lower rates.
- Debt-to-income ratio : Your debt-to-income ratio is the amount of your monthly loan payments divided by your gross monthly income. This number is an important part of your financial profile and overall attractiveness to a lender, as it helps gauge your ability to make loan payments.
Types of personal loans
While most personal loans work similarly, there are differences between loan products and lenders. Here are the main types of personal loans you need to know about:
- Unsecured personal loans: Most personal loans are unsecured, meaning you don’t need to put up any collateral to qualify. With an unsecured personal loan, you get a lump sum of cash, then repay your loan with fixed monthly payments over a fixed repayment period.
- Secured Personal Loan: You need to put up collateral to qualify for a secured personal loan. Instead of putting up cash as collateral, you can use other assets like a house, boat or car. The lender can seize the property if you fall behind on payments.
- Credit-builder loans: Credit-builder loans do not extend your credit limit. These loans are deposited into a savings account controlled by the lender, and you make payments on your balance for the duration of the loan. During this time, lenders report your payments to the credit bureaus to help you build a history of responsible credit use. At the end of the loan, you receive your payment in full, minus the loan fee.
- Specialty Lenders: Some service-oriented companies offer personal loans to help their customers afford their products or services — for example, you can get financing through a home improvement store when you buy a new appliance. These loans are generally convenient but do not always offer the best rates and terms.
Common Uses of Personal Loans
One of the major advantages of personal loans is that you can use your loan amount as you wish. This makes personal loans incredibly versatile and flexible. Here are some of the most common applications.
Debt consolidation loans are unsecured personal loans that require debt consolidation of high-interest credit card debt or other debts. These loans come with low interest rates that help customers save money on interest or secure lower monthly payments.
Consumers with an expensive event like a wedding, honeymoon or graduation party often take out a personal loan to fill the gap in their budget. After the event, they get the benefit of repaying their loan with fixed monthly payments and a fixed interest rate over time.
Invest in yourself
It is common to take out personal loans for educational purchases, such as obtaining a workplace certification or attending a career-boosting seminar. You can also get a personal loan for procedures that improve your self-image, such as dental implants or cosmetic surgery.
Small home improvement projects
Home equity loans and home equity lines of credit (HELOCs) are popular among consumers who want to take on remodeling projects, as these home improvement loans require you to put up your home as collateral. For this reason, many consumers turn to unsecured personal loans instead of home equity products. They can get the money they need for their project with affordable rates and terms, yet they don’t have to put their home on the line.
Personal loans also work well for emergencies, such as unexpected medical bills, urgent roof replacements, or even funeral expenses. Some personal loans allow customers to apply online and receive funds within a few business days, which can provide exceptional peace of mind and financial support in times of emergency.
How to get a personal loan
If you are ready to apply for a personal loan, first take these steps:
- Pull your credit. A high credit score will improve your chances of getting approved for a personal loan with the best rates and terms. If your credit score is on the low side, dispute any errors on your credit report and take steps to improve your credit score before applying.
- Pay off the debt if possible. A low debt-to-income ratio can also help you qualify for a loan with better terms. If your ratio is high – around 45 percent or more – paying off some of your debt or increasing your income can help.
- Get quotes from multiple lenders. Once your finances are in order, get loan quotes from several lenders. Compare APR, loan amount, loan terms and lender reputation. Some lenders offer pre-qualification, which allows you to estimate the terms of your loan without hurting your credit.
- Submit the documents to your lender. When you decide on a lender, you will need to formally apply for a loan and submit various financial information. This may include a bank statement or pay stub. If you don’t have a job, be prepared to show how you can pay. Some lenders accept alternative forms of income, such as unemployment benefits.
- earn money If your loan application is accepted, the lender should send you the funds within a few business days. Then you can use the money for your purpose. Setting up payment reminders can help you avoid late fees and damage to your credit.
Common Mistakes When Using Personal Loans
Here are some common mistakes people make when taking out a personal loan — and how you can avoid them:
- Borrowing more than you can afford : If you take a personal loan and fall behind on payments, it will cost you in the long run. You may have to pay late fees and your credit score may go down. Before taking out a loan, use a personal loan repayment calculator to estimate your monthly payment and check if it fits into your monthly budget.
- Getting stuck with high costs: Collecting quotes from multiple lenders can help you find the best deal and potentially save you interest. Compare interest rates, fees and creditor reputation before applying for a loan.
- Ignoring Loan Costs: Even if you know the interest and charges on your loan, you may not consider how much you’re paying. For example, you borrow $10,000 on a 36-month personal loan with a 10 percent APR and a 6 percent origination fee. You’ll end up paying $600 in origination fees and $1,616 in total interest. Using a loan calculator can help you get an idea of what you’ll pay before taking out a loan — so you can be sure you can afford it.
Alternatives to personal loans
A personal loan may not be the best option for everyone. Depending on your financial situation and how you plan to use the money, it may make more sense to investigate other loan options, including:
- Credit Card: As a revolving line of credit, using a credit card allows you to borrow funds frequently as needed. However, credit cards have some disadvantages, including variable interest rates, annual fees, and late fees. A credit card is also not a good option for large expenses that can incur substantial interest if you don’t pay off the balance in full at the end of each billing cycle.
- Cash-out Refinance: The money from a cash-out refinance can be used for almost any purpose, including home remodeling, paying off high-interest loans, or any other financial need. A cash-out refinance replaces your current home loan with a larger mortgage, and you get the difference between the two mortgages in one lump sum payment. This option can often be a less expensive way to get cash because refinancing rates are generally lower than personal loans.
- Home Equity Line of Credit (HELOC): A HELOC allows you to borrow only when you need it. This approach to borrowing may be better for people who need constant cash. HELOC interest rates are often lower than personal loans.
- Home Equity Loan: A home equity loan is a second mortgage that provides you with a lump sum of money. This type of loan allows you to borrow against the equity in your home, usually at a lower interest rate than other types of loans.