What is a personal loan?
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A personal loan is money borrowed from a lender that can be used for nearly any purpose. These reasons include paying off debt, financing a large purchase such as a vehicle or a boat, or covering the cost of a major expense like a wedding or a home renovation.
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 debt has been fully repaid.
One of the biggest benefits of personal loans versus credit cards is that they come with a fixed interest rate and repayment terms.
What is a personal loan?
A personal loan is money you borrow from a bank or other financial institution with a set repayment period and consistent monthly payments. Most personal loans are unsecured, so you won’t have to put down collateral to borrow the money.
Loan amounts vary widely, from around $1,000 to $50,000 or more, and interest rates currently range from about 6 percent to 36 percent. Borrowers typically get between one and seven years to repay the money.
How a personal loan works
If you’re looking to get a personal loan, you’ll have to complete an application and wait for approval — a process that may take anywhere from a few hours to several days. Once you’re approved, the lender will disburse money into your bank account, and you use the funds for your intended purpose. You will also start to repay the money right away. Throughout the loan term, your lender will likely report your account activity to the credit bureaus. Making on-time payments can help you build a positive credit history.
Here’s an explanation of all the moving parts that make personal loans what they are.
- Interest rates: Personal loans charge borrowers a fixed APR, or annual percentage rate, on top of the principal loan amount. This APR can vary depending on creditworthiness, income and other factors. The personal loan interest rate determines how much interest borrowers pay over the life of the loan.
- Monthly payment: Personal loans come with a fixed monthly payment that you’ll make for the life of the loan, calculated by adding up the principal and the interest. You can typically secure a lower monthly payment if you agree to pay off your loan over a longer stretch of time.
- Repayment terms: Repayment timelines vary for personal loans, but consumers are often able to choose repayment terms between one and seven years. However, some lenders may offer terms of up to 12 years on larger personal loans.
- Origination fees: Some personal loans charge an initial origination fee on top of the original amount of your loan. While origination fees vary, it’s common to see origination fees as high as 10 percent of your loan amount.
How rates are determined
Personal loans may come with a fixed rate, in which the APR stays constant over the life of the loan, or a variable rate, which can fluctuate over time. The APR includes the personal loan’s interest rate in addition to the lender’s fees for servicing the loan.
Lenders sometimes base variable rates on a well-known index rate, such as the prime rate. The prime rate is the interest rate at which banks and other financial institutions lend to one another.
Variable interest rates can be capped so they won’t rise above a certain amount — even if the index rate increases. However, most personal loans come with fixed APRs, which means that your monthly payments will be predictable.
Your APR is determined based on several factors, the most important being your credit score. If you have a good credit score, you may qualify for a lender’s lowest rates — the best rates typically go to people with credit scores above 700. Some of the additional factors that may impact the APR you’re offered include:
- Annual income: Lenders like to see a steady and reliable income source that can be used to make monthly payments. This can also result in a more favorable APR.
- Payment history: Those with a solid history of making on-time payments typically qualify for lower rates.
- Debt-to-income ratio: Your debt-to-income ratio is the amount of your monthly debt 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 among loan products and lenders. Here are the main types of personal loans you should be aware of.
- Unsecured personal loans: Most personal loans are unsecured, meaning you don’t have to put down any collateral to qualify. With an unsecured personal loan, you’ll receive a lump sum of cash, then repay your loan with fixed monthly payments over a fixed repayment timeline.
- Secured personal loans: Secured personal loans require you to put down collateral to qualify. Instead of putting down cash as collateral, you may be able to use other assets, such as a home, a boat or a car. The lender may be able to seize those assets if you fall behind on payments.
- Credit-builder loans: Credit-builder loans don’t extend you a line of credit. Instead, they are deposited into a savings account, and you make payments on your balance for the duration of the loan. Lenders report your payments to the credit bureaus, and at the end of the loan, you receive your payment in full, minus loan fees.
- Specialized lenders: Some service-oriented companies offer personal loans to their customers as a means of helping them afford their products or services. You might, for example, be offered financing by a home improvement store when you buy an appliance. These loans are typically convenient but don’t always offer the best rates and terms.
Common uses of personal loans
One big benefit of personal loans is that you can use your loan proceeds however you want. This makes personal loans incredibly diverse and flexible. Here are some of the most common applications.
Debt consolidation loans are unsecured personal loans offered to consumers who need to consolidate high-interest credit card debt or debt from other loans. These loans tend to come with lower interest rates that can help consumers save money on interest or secure a lower monthly payment.
Financing big events
Consumers with a pricey event like a wedding, a honeymoon or a vacation often take out personal loans to fill the gaps in their budget. Once the event is over, they get the benefit of repaying their loan with fixed monthly payments and a fixed interest rate over time.
Investing in yourself
It’s common to take out personal loans for educational purchases, such as pursuing a workplace certification or attending a career-boosting seminar. That said, many lenders prohibit the use of personal loans to cover college tuition fees, which is something to keep in mind.
Besides investing in your education, you can also get a personal loan to pay for procedures that improve your self-image, such as dental implants or cosmetic surgery.
Home improvement projects
While home equity loans and home equity lines of credit (HELOCs) are popular with consumers who want to take on remodeling projects, 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.
With an unsecured personal loan, you can borrow the money you need for a project without putting your home on the line.
Pay for emergency expenses
Personal loans also work well for emergencies, such as surprise medical bills, an urgent roof replacement or even funeral expenses. Since some personal loans let consumers apply online and receive funding within a few business days, they can provide exceptional peace of mind and financial support when an emergency strikes.
How to get a personal loan
If you’re ready to apply for a personal loan, take these steps first:
- Pull your credit: A higher 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 lower end, dispute any errors on your credit reports and take steps to improve your credit score before applying.
- Pay down debt if you can: A lower debt-to-income ratio can also help you qualify for a loan with good terms. If yours is high — around 45 percent or more — then paying off some of your debts or increasing your income will help.
- Get quotes from multiple lenders: Once your finances are in order, get loan quotes from several lenders. Compare APRs, loan amounts, loan terms and lender reputation. Some lenders offer prequalification, which allows you to estimate your loan terms without hurting your credit.
- Submit documents to your lender: When you decide on a lender, you’ll need to formally apply for the loan and submit various financial information. This could include bank statements or pay stubs. If you don’t have a job, be prepared to show how you plan to make payments.
- Receive the money: If your loan application is approved, the lender should send you the funds within a few business days. You can then use the money for your intended purpose. Setting up payment reminders can help you avoid late fees and bruises to your credit.
Common mistakes when using a personal loan
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 out a personal loan and fall behind on payments, it will cost you in the long run. You may have to pay a late fee, and your credit score may drop. Before taking on debt, use a personal loan repayment calculator to help budget.
- Getting stuck with high costs: Gathering quotes from multiple lenders can help you spot the best deal and potentially save you interest. Compare interest rates, fees and lender reputation before applying for the loan.
- Ignoring the loan costs: Even if you’re aware of the interest and fees baked into your loan, you might not think about how much you’re paying. For example, you can borrow $10,000 but depending on interest and fees the loan could end up costing well over $12,000. Use a calculator to see just how much your loan will cost.
Alternatives to personal loans
A personal loan may not be the best choice for everyone. Depending on your financial circumstances and how you plan to use the money, it may make more sense to investigate other lending options, including:
As a revolving line of credit, using a credit card allows you to repeatedly borrow funds as needed. However, credit cards have some downsides, including variable interest rates, annual fees and late fees.
A credit card is also not a good choice for major expenses, especially because you could accrue substantial interest if you don’t pay the balance in full at the end of each billing cycle.
The proceeds from a cash-out refinance can be used for nearly any purpose, including home remodeling, consolidating high-interest debt or any other financial need. A cash-out refinance replaces your existing home loan with a bigger mortgage and you receive the difference between the two mortgages in a lump sum payment.
This option can often be a less expensive way to access cash because refinance rates are typically lower than personal loans. Just be careful not to borrow more than you need.
Home equity line of credit (HELOC)
A HELOC allows you to borrow only what you need when you need it. This approach to borrowing can be better for people who need access to cash on an ongoing basis. HELOCs often have interest rates that are 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.
If you need to borrow money and prefer the stability of a fixed repayment schedule and fixed monthly payment, a personal loan could be exactly what you need. To get the best loan rates and terms, take steps to become an attractive borrower by improving your credit score and keeping other debts at a minimum.
It’s also important to shop around and compare personal loan rates with multiple lenders in the personal loan space, including companies that offer online loans.
Frequently asked questions
There’s no one best way to borrow money, the best type of loan depends on your financial situation and what your goals are. Personal loans are great for short- to medium-term borrowing at rates that are lower than credit card rates for purposes like debt consolidation, emergencies, or home improvement. However, you typically can’t use one to pay for business expenses, college tuition or the down payment of a house.
Almost anyone can apply for a personal loan, but there’s no guarantee that you’ll get approved. While they can be easier to qualify for than many loans, you’ll still need to have reasonably good credit and a source of income to pay the loan back. If you have collateral to offer, secured personal loans are usually easier to qualify for.
Personal loans usually have lower interest rates than credit cards, making them a better option if you’re planning to borrow money for a midsize to large expense. Credit cards, on the other hand, have the benefit of letting you draw money as you go — something you can’t do with a personal loan.That said, if you’re not careful with your spending, the buy now, pay later approach of a credit card could send you down a cycle of debt, impacting your credit. In the end, the best credit product for you will depend on your money habits and what you need the funds for.