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. Common 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.

You can get a personal loan from online lenders, banks and credit unions, and the funds are provided in a lump sum. Once you receive the cash, you must make recurring, monthly payments until the debt has been fully repaid.

One of the biggest benefits of a personal loan is that they often charge lower fixed interest rates when compared to other forms of lending, like credit cards.

How a personal loan works

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, typically from around $1,000 to $50,000 or more, and interest rates currently range from about 6 percent to 36 percent. Repayment terms typically range from one to seven years.

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. You will also start to repay the money. Throughout the loan term, your lender will likely report your account activity to the credit bureaus, so making on-time payments is crucial to building a positive credit history.

When looking for a personal loan, you’ll come across the following terms.

• Interest rate: 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 over 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, although you will end up paying more in interest accrual than if you had a shorter repayment period.
• 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 fee: 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.

What are the pros and cons of personal loans?

Personal loans have advantages and drawbacks. Before applying, consider how the pros and cons could impact your financial situation and if a personal loan is worth it for you.

Pros

• Lower interest rates: Personal loans typically have lower interest rates compared to credit cards, especially if you have a high credit score.
• Minimal fees: Most personal loans do not charge an application fee, prepayment penalty, maintenance fees or any other type of penalty as long as you stay in good standing. However, some loans may charge an initial origination fee, which will add to the overall cost of your loan.
• Consolidate debt: You can use a personal loan to consolidate expensive debt, such as credit card debt.
• Versatile: You can use personal loans for a variety of purposes.

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Cons

• Qualifications: If you don’t have good credit, you may end up paying a much higher interest rate.
• Payment flexibility: Most personal loans charge fixed interest rates and have a strict repayment schedule.
• Not ideal for emergencies: Personal loans can be used to cover emergency expenses, however, you need to have a plan to be able to make the monthly payments. If you can’t, you risk doing lasting damage to your credit.

How rates are determined

Personal loans may come with a fixed rate, in which the APR stays the same 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 stay the same.

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:

• Income: Lenders like to see a steady and reliable income source that can be used to make monthly payments.
• 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 to know.

• Unsecured personal loans: Most personal loans are unsecured, meaning you don’t have to put down any collateral to get the loan. With an unsecured personal loan, you’ll receive a lump sum of cash, then repay your loan with fixed monthly payments over a 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, boat or 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 for almost any legal purpose, depending on the lender. This makes personal loans incredibly diverse and flexible.

“Using a personal loan is only a good idea when it is consistent with being able to achieve other financial goals,” says Mark Hamrick, Bankrate senior economic analyst and Washington bureau chief. “If one has a significant amount of credit card debt, then I’d say using a personal loan is probably significantly less than optimal,” he adds, noting that the decision to get a personal loan is ultimately dependent on one’s own financial situation.

• Here are some of the most common applications.

Debt consolidation

Debt consolidation loans are a type of personal loan for 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.

While this may be a common reason, Hamrick advises against funding your honeymoon or dream wedding with a personal loan, citing that discretionary events are among the worst uses for a personal loan.

“They’re (the borrowers) really opting to provide their combined personal finances a setback even before they are married,” he says. “Creating unnecessary financial stress for a young marriage is a decision to be avoided.”

Investing in yourself

Personal loans can be used for some educational purchases, such as pursuing a workplace certification or attending a career-boosting seminar. However, many lenders prohibit the use of personal loans to cover college tuition fees.

You can also get a personal loan to pay for procedures that improve your self-image, such as dental implants or cosmetic surgery. Hamrick encourages borrowers to look at what’s medically necessary versus what isn’t before taking out a loan for procedures, especially after looking at the loan’s rate and terms.

“For a discretionary purchase in this category, one key question is how the loan would affect their broad financial goals and capabilities,” he says, adding that if the procedure is a medical necessity, then a loan may be one of the ‘least worst’ options.

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. Because 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:

1. 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 you have a lower credit score, consider waiting to apply for a personal loan to prioritize improving your credit.
2. Pay down debt if you can: A lower debt-to-income ratio can also help you qualify for a loan with good terms. If your DTI is high — around 45 percent or more — then paying off some of your debts or increasing your income will help.
3. 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.
4. Submit documents to your lender: When you decide on a lender, you’ll need to formally apply for the loan and submit the required documentation. This could include bank statements or pay stubs. If you’re currently employed, you may be required to show proof of income or sufficient funds to make the payments.
5. 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 five common mistakes people make when taking out a personal loan — and how you can avoid them:

1. Getting a longer loan term than necessary: The longer the loan term, the more interest you’ll have to pay during the life of your loan. Before taking on debt, use a personal loan repayment calculator to help budget.
2. Not shopping around for the best offers: 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.
3. Not considering your credit score: Your credit score is a big factor in determining your eligibility for the loan as well as the interest rate. Some lenders may also charge higher origination fees for less creditworthy borrowers. Before applying, know what your score is so that you know what to expect in terms of costs.
4. Overlooking fees and penalties: Be on the lookout for hidden fees and penalties by reading the lender’s terms and conditions page so you don’t end up paying more than you had planned. You can use a loan calculator to see how much your loan will cost in total.
5. Not reading the fine print: Before you sign and finalize the loan agreements, review everything so that you’re well aware of the loan terms and don’t accidentally violate them.

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 consider other lending options, including:

Credit card

Credit cards are a revolving line of credit, meaning you can repeatedly borrow funds as needed, up to your credit limit. 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.

Cash-out refinance

The home equity you withdraw in a cash-out refinance can be used for almost any purpose, such as remodeling your home or consolidating high-interest debt. 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 typically be a less expensive way to access cash. However, mortgage rates have been rising rapidly. Because of this, it doesn’t make sense for most homeowners to refinance at today’s rates.

Home equity line of credit (HELOC)

A HELOC is a line of credit that allows you to borrow what you need, when you need it — similar to a credit card. With a HELOC, though, you have a maximum borrowing amount that’s backed by the equity you’ve built up in your home. A HELOC can be better for people who need access to cash on an ongoing basis, as the funds aren’t disbursed in one lump sum like other loans.

While you will have to use your home as collateral to back the loan, HELOCs may have interest rates that are lower than personal loans.

Home equity loan

A home equity loan is a type of second mortgage that provides you with a lump sum of money based on the equity you’ve built up in your home. Unlike HELOCs, home equity loans are more useful for short-term, smaller home renovations or projects in which you know the total amount of cash you’ll need from start to finish.

Home equity loans usually come with lower interest rates than other loans. Your home will be used as collateral and could be seized to satisfy the delinquent payments if you default on the loan.

Next steps

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, work on improving your credit and paying down existing debt in order to get the most competitive loan rates and terms.

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

• Is a personal loan the best way to borrow money?

  There’s no one best way to borrow money. The best type of loan depends on your financial situation and goals. Personal loans are great for short- to medium-term borrowing at rates that are typically lower than credit card rates.

  Common uses include debt consolidation, emergencies and home improvement. However, you typically can’t use one to pay for business expenses, college tuition or a home down payment.

• Can anyone get a personal loan?

  You’ll need to provide some basic documentation to verify your personal and financial information to get approved, but there is no guarantee.

  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 back the loan. If you have collateral, secured personal loans are usually easier to qualify for.

• Are personal loans better than credit cards?

  Personal loans typically 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. Depending on the credit card, you may be able to earn rewards or cash back on eligible purchases.

  Ultimately, the best credit product for you will depend on your money habits and what you need the funds for.