What Is a Personal Loan? How Do They Work?

A personal loan is a type of bank loan. You’re essentially getting a lump sum of money from a lender. You agree to repay the borrowed amount over a specified period, usually with interest. The repayment period can range from a few months to several years, depending on the loan terms and your agreement with the lender.

The loan amount, interest rate, and repayment term are established during the application process and outlined in the loan agreement. When you decide to get a personal loan, you’ll start by applying with a lender of your choice. The lender will send the funds to your checking account if your loan is approved.

Afterward, you’ll start making monthly payments on the loan based on the terms you agreed on with the lender. Shorter terms usually mean higher monthly payments but less interest paid overall, while longer terms result in lower monthly payments but potentially more interest paid. Common repayment terms range from one to seven years, depending on the lender and the loan amount.¹

Each payment consists of principal (the amount you borrowed) and interest (the cost of borrowing). The interest rate depends on your credit score, financial history, and current market rates.

Personal loans can be used for a wide range of purposes. Here’s an overview of common ways you can use personal loans:

• Consolidating debt: You can use personal loans to consolidate high-interest debts like credit card balances or medical bills into a single, more manageable monthly payment.
• Emergencies: A personal loan can provide quick access to funds when faced with unexpected emergencies, like car repairs or urgent home repairs. However, an emergency fund can help you avoid taking out a personal loan for unexpected expenses.
• Medical expenses: A personal loan can cover unforeseen medical bills or elective medical procedures, allowing you to manage your health-related expenses.
• Home improvements: Personal loans can help fund home renovation or repair projects, like upgrading your kitchen, fixing your roof, or enhancing your backyard.
• Travel and vacations: If you want a dream vacation but need upfront funds, a personal loan can be a solution to finance your travel plans.
• Weddings: Weddings can be expensive. A personal loan can help cover venues, catering, and other wedding-related expenses.
• Business funding: Entrepreneurs and small business owners can use personal loans as initial capital or to cover operational expenses.
• Moving costs: Whether you’re relocating for work or personal reasons, personal loans can help cover moving expenses, like transportation, movers, and settling-in costs.
• Other major purchases: If you’re planning a significant purchase like new furniture, appliances, or electronics, a personal loan can help.

Personal loans can be used for various financial needs offering flexibility and the ability to quickly secure funds can make all the difference in your time of need.

Personal loans aren’t only used when someone needs to borrow a large amount of money. Loans can also be small, ranging from $1,000 to $10,000, and cater to those who need anything from a few hundred to a few thousand dollars.²

Small loans are ideal for short-term financial needs. They can cover expenses like a minor home repair or unexpected medical bills or help you with temporary cash flow so you don’t have to take on high-interest medical debt. Despite their size, these loans still require consideration and planning to ensure you can comfortably manage the repayment.

The application process for small loans is similar to applying for a loan to borrow a larger amount. Keep in mind that some lenders have minimum borrowing requirements, which are typically $1,000, but it can be less or more than this amount.²

There are a few types of personal loans for different financial needs and circumstances. There are two broad categories of personal loans: secured and unsecured loans. Here’s an overview of the different types of personal loans:

• Unsecured personal loans: Unsecured personal loans are typically higher since they don’t require collateral, like a home or car, as security. Lenders assess your creditworthiness based on your credit score, income, and financial history.
• Secured personal loans: Secured personal loans are backed by collateral, which means you put down a valuable asset like a car or your home to qualify instead of cash. Collateral reduces the lender’s risk, often leading to lower interest rates. However, the lender can claim the collateral if you fail to repay the loan.
• Debt consolidation loan: Debt consolidation loans combine multiple debts into a single loan with a potentially lower interest rate. They make it easier to fit debt payments into your monthly budget and save you money over time.
• Credit builder loans: Credit-builder loans are best for people with limited or poor credit history. Your lender sets aside a predetermined amount of money for you to pay off, typically in monthly payments. Making these payments on time builds a reputable credit history that the lender reports to credit bureaus. Once you’ve paid off the agreed amount, you receive access to the full loan.
• Personal line of credit: Instead of a lump sum, a personal line of credit is an unsecured loan that gives you access to a certain amount of funds that you can draw from as needed.³ This borrowing option usually has a variable interest rate, but it’s also more flexible for ongoing expenses or emergencies.⁴

Some lenders specialize in specific types of personal loans, like medical loans for health care expenses or education loans for tuition and related costs. These lenders may offer specialized terms and benefits for those specific needs.

A good credit score will improve your approval odds if you’re after a standard, unsecured personal loan. We’ll discuss how to get a personal loan below.

When you’re ready to apply for a personal loan, there are several steps you’ll need to follow. You can start by checking your credit since lenders will use your credit score to determine the risk of you being able to pay back the loan on time. Review your credit report to see where you stand, and take steps to improve your credit score before applying if needed.

Research different lenders and compare their interest rates, fees, and customer reviews. Once you’ve chosen a lender, you can apply and submit the personal loan requirements, like identification and proof of income (pay stubs and tax returns). If your loan application is accepted, you can accept and receive your funds, which can take a few business days.

If you’re wondering ‘should I take out a personal loan’, pay attention to a few key factors to choose the best personal loan for you:

• Interest rate: The interest rate significantly affects the overall cost of the loan. Look for a competitive interest rate – lower rates can save you money over the life of the loan.
• Repayment term: Choose a term that balances manageable monthly payments with reasonable interest payments. Loan terms typically range from one to seven years, with longer terms resulting in lower monthly payments but higher total interest costs.¹
• Fees: Review the loan’s fee structure. Common fees include origination fees, prepayment penalties, and late payment fees. Origination fees typically range from 1% to 6% of the loan amount and are either deducted from the loan proceeds or added to the balance.⁵ When comparing loans, factor in these fees to understand the true cost. But always look for loans with minimal fees and extra charges.
• Funding time: Time is crucial, especially if you need funds for an emergency or time-sensitive purchase. Look for lenders with a reputation for quick approval and disbursement of loan funds.
• Repayment flexibility: Check if the lender provides flexible repayment options. Some may offer the choice of monthly, biweekly, or other payment frequencies. Flexible repayment can help you keep your budget on track.

With these details in mind, you can choose a personal loan that aligns with your financial goals and circumstances.

Let’s look at some examples of personal loans to see how loan costs can affect your monthly payment as well as what you’d pay over the life of your loan. Say you borrow $10,000 with an APR of 9% and a 5-year repayment term.

Your monthly payment would be about $208, and over the course of the loan, you would pay approximately $12,455.01 in total.⁶ APR stands for annual percentage rate and includes the interest rate for the loan along with any additional fees representing the cost of borrowing your loan amount.⁷

Now, consider if you have good or excellent credit and qualify for a lower interest rate of 5% on the same $10,000 loan with a 5-year term. In this case, your monthly payment would drop to about $189, and you would pay only $11,322.74 over the life of the loan. This would save you over $1,132.27 in interest compared to the higher rate.

If you don’t have good credit, you could potentially use a personal loan to build credit.

When searching for personal loans, consider both traditional and online lenders.

Traditional banks and credit unions can offer competitive rates to loans for existing customers but may have stricter eligibility requirements. Online lenders tend to have faster approval processes and more flexible loan terms, but they may charge higher fees or interest rates.

Shop around and compare offers from multiple lenders before committing to a loan. Personal loans are significant financial decisions that can affect your finances for several years, so take the time to make an informed choice.

While personal loans can be a valuable financial tool, in some situations, it may not be the best option. Here are some alternatives to consider.

• Credit cards: If you need funds for smaller expenses, using a credit card might be more practical. Many credit cards offer 0% introductory APRs, allowing you to pay off the balance without incurring any interest, similar to buy now pay later programs. However, if you’re unable to pay off your debt within the promotional period, you could face high-interest charges and potentially damage your credit score.
• Buy Now, Pay Later loans: Buy Now, Pay Later (BNPL) programs can offer a convenient alternative to personal loans for people looking to spread out the cost of certain purchases without immediately borrowing a lump sum.⁸ BNPL services allow you to break down a purchase into smaller, often interest-free installments over a short period – typically weeks or months. The major downside is that these options won’t provide you with cash in hand for a range of expenses you may need to cover. Instead, you can just use this option to fund certain purchases.
• Home equity line of credit (HELOC): If you’re a homeowner, a HELOC allows you to borrow against the equity in your home. It may also provide a lower interest rate compared to personal loans. It’s an open line of credit so you can borrow money as you need it during what’s called a draw period. The draw period can last several years and afterwards you enter a repayment period. HELOCs tend to have a variable interest rate.⁹
• Home equity loan: Similar to a HELOC, a home equity loan allows you to borrow against your home’s equity. It provides a lump sum with fixed monthly payments but it’s a secured loan where you use your home as collateral.¹⁰

Before pursuing any alternative, carefully consider your financial situation and research the pros and cons of each option. Then, you’ll be able to choose the best fit for your specific needs and circumstances.

A personal loan is a practical financial tool that allows you to borrow money for a variety of purposes with fixed monthly payments. Personal loans can help you consolidate debt or cover a major expense, but do your research and consider your budget.

Need money fast and considering a payday loan? Compare personal loans vs. payday loans to see what benefits personal loans have over payday loans.