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Personal Loans

How Do Personal Loans Work? A Guide for Beginners

Personal loans are incredibly versatile, allowing you to use your funds for almost anything you want, with only a few exceptions. They’re commonly used for debt consolidation, emergency expenses, home improvement projects, and other large purchases.

But how do personal loans work, and how do you get one? Here’s everything you need to know before you apply.

In this guide:

What is a personal loan? 

A personal loan is a type of installment loan that you can use for a variety of purposes. When you get approved for a personal loan, you’ll receive your proceeds in a lump sum, less any upfront fees. Then, you’ll make equal monthly payments for a set period. 

Depending on the lender, you can borrow between $500 and $100,000, and repayment terms often range from one to seven years. Unlike credit cards, personal loans typically offer fixed interest rates, meaning your rate and the monthly payment will stay the same for the life of the loan.

Are there different types of personal loans?

Personal loans can be broadly divided into two categories: unsecured and secured personal loans. Here are the key differences:

Unsecured personal loanSecured personal loan
Most common type of personal loan, offered by various banks, online lenders, and credit unionsLess common type of personal loan, typically offered by credit unions
No collateral required for approvalCollateral, such as your house, car, savings account, CD, or investment accounts,  required for approval
Available to borrowers with any credit score, including good credit, fair credit, and bad credit; bad-credit personal loans typically come with high interest rates, hefty fees, and shorter repayment termsGenerally easier to qualify for a secured personal loan, especially if you don’t have good credit. 
Tend to have higher interest rates, but if you have excellent credit, you can still qualify for a single-digit interest rateTypically have lower interest rates than unsecured personal loans
If you default, no collateral is seized, but the lender may seek other ways to collect, including filing a lawsuit against youIf you default, the lender can seize your collateral and use it to recoup the remaining loan balance

What can a personal loan be used for?

For the most part, you can use personal loan funds for just about anything you want. Some lenders may even brand their personal loans for specific ways to use them, such as debt consolidation loans, home improvement loans, or wedding loans

That said, some lenders may have limitations on how you can use your loan funds. Commonly prohibited uses include:

  • Education-related expenses, including consolidating student loan debt
  • Investments
  • Business expenses
  • Home down payment (this restriction typically comes from the mortgage lender)
  • Gambling
  • Illegal purposes

Of course, lenders aren’t tracking your bank account to ensure you’re using the money for allowed purposes. However, if you default on the loan and the lender investigates how you used the money, you could be disadvantaged in the negotiation process.

Where can you get a personal loan?

You can get personal loans from various lenders, including traditional banks, credit unions, and online and peer-to-peer lenders. Personal loans typically work the same regardless of the lender, but the exact terms can vary. 

Traditional banks

Traditional banks are for-profit financial institutions and can include national, regional, and community banks. 

Banks tend to be more conservative in their lending standards than online lenders, which means more stringent credit requirements on bank loans. They may also charge higher interest rates and fees

Credit unions

Credit unions are member-owned not-for-profit organizations that return profits to their members through lower interest rates and fees. 

If you’re a member, you may be able to secure a credit union personal loan more easily at a lower rate than from a bank. Credit unions may also have better customer service than banks. 

That said, credit unions often limit their membership to a specific state or region or members of certain organizations, so there’s an extra step involved with the loan application process. 

Online lenders

Online lenders don’t have physical branches to maintain, so they can often provide lower interest rates and fees than traditional banks and even some credit unions. Online lenders are also more likely to offer personal loans to borrowers with less-than-stellar credit histories. 

In some cases, you can even get faster funding with an online lender—some even tout same-day funding.

Peer-to-peer lenders

When you get a peer-to-peer loan from platforms such as Upstart and Prosper, the loan comes from individuals who sign up to invest their own money in loans. 

The peer-to-peer lending company facilitates connecting you with investors and collecting payments instead of lending you money directly.

Like online lenders, peer-to-peer lenders may have less stringent credit requirements than traditional banks and credit unions, opening up opportunities for people with poor or fair credit to get approved.

How does a personal loan work?

Getting a personal loan can vary slightly depending on the lender, but some general guidelines can help you know what to expect.

1. Shop around and compare interest rates

Each lender has its own set of interest rates, fees, repayment terms, and credit requirements, so it’s a good idea to take some time to compare personal loans from multiple lenders before you apply.

Fortunately, many lenders allow you to get prequalified with a soft credit check, so you don’t have to worry about the rate-shopping process hurting your credit score. Try to get rate quotes from at least three to five lenders to get a good idea of what you qualify for.

2. Choose a lender

Once you’ve gone through the prequalification process with a handful of lenders, select the lender that offers the best terms for your credit profile. 

In addition to the interest rates, look at whether the lender charges an origination fee, which repayment terms you have to choose from, and what the monthly payment would look like.

Once you narrow your list of options to one lender, you can work directly with them to apply.

3. Submit an application

You can usually apply with your chosen lender online, and some lenders may also allow you to use the phone or apply in person at a local branch. 

An online personal loan application typically only takes a few minutes to complete and usually requires the following information about you:

  • Full name
  • Date of birth
  • Social Security number
  • Address
  • Email address and phone number
  • Employment and income details

You’ll also share your desired loan amount and repayment terms. The lender may require you to provide a copy of your government-issued photo ID and income documents, such as pay stubs or a tax return.

Once you apply, the lender will run a hard credit inquiry on your credit reports to get a complete picture of your credit profile. It’ll review your credit score, other debts, income, and other factors to determine whether you qualify and what your interest rate will be.

4. Review the loan offer 

After you submit your application, you’ll receive a decision. In some cases, you’ll find out whether you’ve been approved in seconds. In others, it may take a day or two to respond.

If you’re approved, carefully review the loan offer from the lender—it may or may not be the same as the initial quote you received during the prequalification process. Again, it’s important to look out for potential fees that could reduce how much you receive.

If you agree with the loan terms, you can usually sign the agreement electronically. If you opt to have the funds deposited into your bank account, you’ll need to provide the account details. 

Alternatively, you can request a paper check or—if you’re using the loan to consolidate other debt—have the lender pay off other debts directly.

5. Receive your funds and start repayment

Depending on the lender, you could receive your loan funds as soon as the same day on which you were approved. In most cases, though, depositing the proceeds into your account may take a day or two. 

If you opted to receive a check or asked the lender to pay off some debt directly, the process can take several days. Once you receive the funds, you can use them for your intended purpose.

Now is also a good time to set up automatic payments on your loan so you don’t accidentally miss one. Some lenders may discount your interest rate for being on autopay. Usually, the discount is 0.25%, but some lenders go as high as 0.50%.

Personal loan rates, terms, fees, and limits

There are several details to review when comparing personal loans. Many of these features can directly impact your monthly payment and how much interest you’ll pay over the life of the loan. 

Here are the most important factors to keep in mind.

Interest rate

The interest rate on a personal loan is the primary cost of borrowing, and it’s determined based on your creditworthiness. Lenders apply the interest rate to your principal loan balance to calculate how much interest you owe monthly. 

When you pay each month, a portion pays off the interest accrued since your last payment, and the remainder pays down the loan balance.

What to look for: Most personal loan interest rates are fixed and remain constant for the life of the loan. Interest rates among top lenders range from 5.99% to 35.99%.


Short for annual percentage rate: APR is often used interchangeably with interest rate, but they’re not the same. While a loan’s interest rates represent the annual cost of interest, the APR represents the total cost of borrowing, including interest, fees, and other finance charges. 

What to look for: When comparing rates between lenders, it’s usually the APR you see. If a personal loan charges an origination fee, for instance, the APR will typically be higher than the interest rate.

Origination fees

An origination fee is an upfront charge that some lenders charge to cover the costs of reviewing your application and disbursing the loan. They’re usually deducted from the loan disbursement before you receive the money. 

What to look for: Origination fees can range from 0% to 10% of the loan amount. If your loan has an origination fee, you may need to borrow more to get the total amount you need.

Repayment terms

The time you have to repay the loan. You’ll choose your repayment term before you agree to the loan offer, and the lender will calculate your monthly payment based on the loan’s interest rate and term. 

Long-term loans can keep your monthly payments low, but you’ll pay more in total interest charges. Short-term loans can help you save on interest, but the monthly payments will be higher.

What to look for: Among top personal loan companies, loans typically have repayment terms ranging from one to seven years, but some lenders offer more flexibility. Some lenders may only have two terms, while others provide a wider spectrum.

Prepayment penalties

Some lenders may charge a prepayment penalty if you pay off your loan too early. The fee effectively protects lenders against losing their expected interest income on the loan.

What to look for: A prepayment penalty may be a percentage of the loan amount or a fixed amount based on the total interest you’d pay over the life of the loan. 

Most top personal loans don’t charge a prepayment penalty, but thoroughly reviewing the loan agreement is still a good idea to avoid surprises.

Funding time

Funding time is the time it takes to receive your loan money from the lender.

What to look for: With online lenders, you can typically expect to receive the money within a day or two of approval. Some offer same-day funding. With traditional banks and credit unions, it could take up to a week.

Qualifying requirements

Personal loans are available to borrowers across the credit spectrum, but each lender has criteria for determining whether you qualify, how much you can borrow, and what your interest rate and fees will be. 

What to look for: Lenders typically consider three factors:

  • Credit score: Most personal loan lenders require a credit score in the 600s, but some specialize in working with borrowers in the 500s or lower.
  • Credit history: When lenders run a full credit check, they’ll look at your existing debts and payment history and check for major negative items on your credit report, such as bankruptcy or foreclosure, which can indicate that you could be at risk of defaulting on your payments.
  • Debt-to-income (DTI) ratio: Lenders will add up your monthly debt payments and divide the sum by your gross monthly income to determine your DTI. Lenders usually like to see a DTI of 40% or less, but some may go higher.

Before applying for a personal loan, checking your credit score using a free service to gauge your approval odds is a good idea.

Loan amounts and limits

Loan amounts and limits refer to the amount of money you can borrow with your personal loan.

What to look for: Depending on the lender, you can usually borrow between $500 and $100,000. Some lenders may have less flexible personal loan limits. Before comparing options, determine how much you need to borrow, then focus on lenders that can meet that need.

How personal loans compare to other types of financing 

While personal loans can be a great way to get the financing you need, there are several alternatives from which you can choose. Here’s a quick summary of each.

Loan amountsAPRRepayment termsCommon costsBest for
Personal loan$500 – $100,0005.99% – 35.99%1 – 7 yearsOrigination feeBorrowers with good or excellent credit who want a fixed payment and term
Credit card$200 – $80,00010% – 35%No fixed repayment term; monthly payment is based on your balanceAnnual fee, balance transfer fee, cash advance feePeople who want a revolving line of credit for everyday purchases
Home equity loan $10,000 – $1,000,000; your limit based on how much equity you have in your home6% – 16%5 – 30 yearsClosing costsHomeowners who have a lot of home equity and want a lump-sum disbursement
Home equity line of credit$10,000 – $1,000,000; your limit is based on how much equity you have in your home6% – 16%15 – 30 yearsClosing costs, annual feeHomeowners who have a lot of home equity and want a revolving line of credit they can use over and over again
Payday loan$100 – $1,000300% – 650%14 daysFinance chargesBorrowers with no other way to get access to cash

Personal loans vs. credit cards

Unlike personal loans, credit cards don’t have a fixed repayment schedule. Instead, you’ll get a minimum monthly payment, which is calculated based on your balance from the previous month. That said, paying off your balance in full each month can avoid credit card interest.

Credit cards also offer a revolving line of credit, which you can use, pay off and use again. The total amount you can borrow is your credit limit, which is determined using your credit history, income, and other factors. 

Many credit cards also offer benefits, such as rewards, 0% APR promotions, insurance protections, and travel perks.

While some personal loans charge higher interest rates than credit cards, they are often used to consolidate high-interest credit card debt at a lower rate. Credit cards don’t charge an upfront origination fee, but they may charge an annual fee and a fee for balance transfers or cash advances. 

Personal loans vs. home equity loans

Home equity loans are another popular option for debt consolidation and home improvement. These loans are secured using your home as collateral. As a result, they typically offer lower interest rates and longer repayment terms.

Also, if you use your home equity loan funds to buy, build, or substantially improve the home you’re using as collateral, you may be able to deduct the interest you pay on the loan on your tax return.

However, the amount you can borrow will be limited based on how much equity you have in your home—you can typically only borrow up to 85% of your home’s value between your primary mortgage and your home equity loan. 

Home equity loans can also charge closing costs that range from 2% to 5% of the loan amount. And if you default on payments, the lender could foreclose on your home.

Personal loans vs. home equity lines of credit

Like credit cards, home equity lines of credit (HELOCs) are a type of revolving debt. You’ll get a credit limit, which may be limited based on how much equity you have in your home—the 85% limit that applies to home equity loans is also typical here. 

You’ll get up to 10 years to draw from your HELOC, during which you only have to pay interest. Once that ends, your repayment term can be as long as 20 years, during which you’ll make full monthly payments until the debt is paid in full. 

HELOC interest rates are typically variable, so they fluctuate over time.

Like home equity loans, you use your home as collateral, and you may be able to deduct the interest you pay in certain situations. However, that also means your home could be at risk if you fail to make payments. HELOCs typically charge closing costs, annual fees, and draw fees. 

Personal loans vs. payday loans

Payday loans are designed for people with extremely poor credit, primarily because you typically don’t need to undergo a credit check to get approved. However, these small-dollar loans typically have short repayment periods—often 14 days—and charge an average APR of 400%.

As a result, it’s best to avoid payday loans if possible. Instead, consider personal loans for bad credit

Is a personal loan a good idea?

Before you start shopping around, it’s important to consider whether a personal loan is the right option for you to begin with. Here are some questions to ask yourself to determine whether to proceed.

Is it the most cost-effective option?

Depending on your reason for borrowing money, consider whether you can achieve your goal less expensively. 

For example, if you want to consolidate high-interest debt, you may consider a balance transfer credit card with a 0% APR promotion instead. A 0% APR credit card could also be a better alternative for a major purchase.

But if getting another credit card could make you complacent with your monthly payments, a personal loan could ultimately save you money. Take your time to compare other alternatives to determine which one can provide you with the most interest savings.

What is the total cost of the loan? 

As you compare rate quotes, use a personal loan calculator to understand how much a loan would cost you, not just in terms of the monthly payments but also in total interest charges. This is particularly important if you have fair or poor credit and may end up with a high interest rate.

If you plan to take out a personal loan for something you don’t need, such as a vacation or another large discretionary purchase, understanding the total cost may help you take a step back and consider waiting to purchase until you’ve built up the savings to pay for it.

Can you afford repayment? 

As you run the numbers, review your budget to determine whether you can afford the monthly payment without putting a strain on your budget or other important financial goals. If adding the payment would spread you too thin financially, you could risk defaulting on your payments. 

How do I choose the best personal loan?

With so many options available, here are some steps you can take to ensure you get the best personal loan offer available to you.

Shop around

Shopping around and comparing interest rates, fees, repayment terms, and other features is one of the most important things you can do to maximize your savings. 

Each lender has its own set of interest rates and credit criteria, so while your financial and credit profile remains the same, some lenders may offer better terms than others.

You’ll want to get quotes from at least three to five lenders and compare terms. You can compare our top choices on our best personal loans page.

Get prequalified

During the comparison process, look for lenders that offer prequalification, or a soft credit check, that doesn’t require hard credit inquiry. This allows you to compare terms based on your credit profile without committing or having the inquiry appear on your credit report.

You’ll need to provide some basic information about yourself, then you’ll typically be able to see potential interest rates, loan amounts, fees, repayment terms, and monthly payments. In most cases, the process only takes a few minutes.

Just keep in mind that your prequalification quote may not be the same as your final offer—the lender will run a full credit check to provide those details.

Consider a cosigner or co-applicant.

If you have a loved one with good or excellent credit, consider asking them to apply with you as a co-applicant or a cosigner. Even if your credit is in good shape, doing so could improve your chances of being approved and receiving the best rates.

Note, however, that not all lenders allow cosigners and co-applicants. Ensure you know the lender’s policy before you start the application process to avoid wasting your time. 

Also, if you add someone to your application, remember that they’ll become equally responsible for paying the debt, and the loan will be added to their credit report. 

Make it a priority to make your payments on time, and when your credit has improved, consider refinancing the debt on your own to relieve them of the responsibility.


Can you refinance a personal loan?

Yes, it’s possible to refinance a personal loan with another personal loan or with another type of debt, such as a 0% APR credit card, home equity loan, or HELOC. 

You may consider this option if you have a high interest rate on the personal loan and can qualify for better terms with a new personal loan or another type of debt.

Just make sure you read the loan agreement and look for prepayment penalties.

Can you have more than one personal loan at one time?

Yes, having more than one personal loan at once is possible. However, your options may be limited if your existing personal loan has a high monthly payment relative to your gross income or your DTI is generally high. 

How does having a personal loan affect my credit?

A personal loan can impact your credit score in a few ways:

  • Credit inquiry: When you apply for a loan, the hard credit inquiry may temporarily knock a few points off your credit score.
  • New account: Opening a new credit account will reduce your average age of accounts, which can negatively impact your credit score. Also, the new debt can potentially impact your credit.
  • Payments: Missing a payment by 30 days or more could significantly and negatively impact your credit. Conversely, making on-time payments can help you build and maintain good credit over time.

Credit score calculations are complex, so it’s impossible to say exactly how a personal loan can impact your score. However, using credit responsibly, in general, will help improve your credit history in the long run.