How Do Personal Loans Work? A Guide for Beginners

When you need to borrow money, you can choose from many different types of loans and other financial products. One of those options is a personal loan. Personal loans, sometimes called installment loans, allow you to borrow a fixed amount of money and pay back what you borrowed over a preset period of time called the repayment term.

In this guide:

• An Overview of Personal Loans
• How Personal Loans Work
• How Is a Personal Loan Different from Other Loan Types
• Types of Personal Loans
• How Do You Get a Personal Loan?
• Personal Loan Rates, Terms, Fees, and Limits
• Where Can You Get Personal Loans?
• When Is a Personal Loan a Good Idea?

An Overview of Personal Loans

Personal loans can be obtained from a local or national bank, credit union, or online lender.

The interest you’ll pay and the other terms of your loan will vary depending upon who you borrow from. Borrowers with good credit will qualify for the best personal loan rates, but most people — even those who are still building or improving their credit score — should be able to obtain a personal loan from an appropriate lender.

Before you begin the application process, you should understand what a personal loan is, how it compares to other loan options, and how to find a good personal loan. This guide to how personal loans work will help you to answer all your questions so you can decide whether taking out a personal loan is a smart financial choice.

How Personal Loans Work

Many people take out personal loans to refinance and consolidate existing debts they owe. This would mean borrowing and using the loan proceeds to pay back existing debts, including medical loans and credit card balances. You could also take out a personal loan for a host of other reasons, from paying for fertility treatments to improving your home, covering wedding costs, or paying for a big purchase.

You’ll receive the entire loan amount at once when you borrow and will pay it back in fixed monthly installments over time. Your payment schedule, which you’ll agree to with your lender up front, will be based on how much principal and interest must be paid each month to pay the loan off in full by the end of the repayment term.

How Personal Loans Are Used

One of the best things about personal loans is that lenders don’t care what you use the money for, and many lenders don’t even ask.

While some lenders market personal loans to specific borrowers by calling the loans “debt consolidation loans” or “wedding loans,” the reality is that you’ll have far more options for funding if you simply look for a general purpose personal loan and then use it to do what you like.

Consolidating debt is an especially common reason for taking out a personal loan because having just one lender to repay makes becoming debt free easier. Plus, personal loans usually have lower rates than credit cards and other debts commonly consolidated, so you can drop your interest rate by taking out a loan.

You don’t have to just use a personal loan for consolidation of other debts, though. Any time you have something you need that you can’t afford to pay for up front, a new loan could be a good source of funding. 

In fact, while many people default to using credit cards for big expenses they can’t afford, a personal loan might actually be a better solution in many cases because the interest rate should be lower than the rate on most cards.

Some personal lenders have a few restrictions on what you do with the loan amount, such as not allowing you to use the money to pay for school or buy a car. However, in most cases, you can simply borrow what you want—as long as you qualify—and the money will be deposited in your bank account so you can use it for your desired purposes without any oversight.

>> Read More: What can a personal loan be used for?

How Repayment Works for Personal Loans

When you take a personal loan, the repayment term will be established up front with your lender; unlike with credit cards, you will know exactly when you’ll be debt-free. Most loan agreements require a loan to be repaid over either a three-year or five-year period, but some allow for longer repayment terms. Others give you only a year or two to repay what you’ve borrowed.

Your monthly payment is calculated based on the amount of principal and interest you’d need to pay to hit the target deadline for repayment. If you have a fixed rate loan, the monthly payment will never change because your interest will always stay the same. But if you have a variable rate loan, your interest rate can change—and so can your payment.

How Is a Personal Loan Different from Other Loan Types

Personal loans are an alternative to credit cards, as well as home equity loans, home equity lines of credit, and alternative loans such as payday or car title loans.

Personal loans differ in important ways from these other types of financing.

Personal Loans vs. Credit Cards

While personal loans give you the ability to receive a fixed amount of money you can do what you’d like with, credit cards give you a line of credit, which is a maximum amount you can borrow — such as $5,000.

As you borrow on your credit card, your payment is determined based on your outstanding balance. The more you borrow, the higher your payments. But minimum payments are usually quite low — typically around 1.5% to 3% of the outstanding balance or a flat amount like $10 or $25. If you make only minimum payments, it can take you many years to pay off your borrowed funds.

Credit cards are called revolving debt because as you borrow and repay your debt, you can borrow again. If you have a $5,000 credit line, you could charge $2,000, pay it back, and then charge another $5,000. Then, you could pay that back and charge another $500, and so on. You can keep this cycle going as long as you want, continuing to borrow until you hit your maximum credit line and then borrowing again once you’ve paid back some or all of what you owe.

And as long as you don’t carry a balance on your card or make any late payments, you’ll never pay an annual percentage rate on your credit. 

With personal loans, you don’t get more money after you borrow, and you don’t just make tiny minimum payments. You make payments according to a specific repayment schedule that allows you to become debt-free in a timeline determined in the loan agreement. If you borrow $10,000, even after you’ve paid back $5,000, the lender won’t give you another $5,000.

In most cases, credit cards have higher interest rates than personal loans, which makes them a more expensive type of debt. However, some credit cards offer special promotional rates for a limited time, such as 0% APR. These can be cheaper in the short term.

It can also be faster and easier to qualify for credit products than a personal loan. With a credit card application, you usually just provide your Social Security number and a few basic financial details such as your income.

With personal loans, you’ll likely need to provide more information, such as info about your other debt. The lender may also want to see proof of your assertions about your financial life, such as pay stubs. It can take time to get your loan funded and approved. While some personal loan lenders make funds available within a few days of applying, for others it can take a week or more.

>> Read More: Personal loans vs. credit cards

Personal Loans vs. Home Equity Loans

Personal loans and home equity loans have some similarities. They’re both loans for a fixed amount, and each could be offered at a fixed or variable interest rate, which is usually lower than credit card interest rates. Both also have a set repayment timeline, and monthly payments are determined based on principal and interest needed to pay the loan on time.

However, the big difference between personal and home equity loans is that a home must secure the home equity loan while a personal loan could be secured or unsecured (and usually assets such as a bank account guarantee the secured ones). 

When a home secures a loan, it acts as collateral to guarantee repayment of the loan. If you don’t pay the loan back, you could be foreclosed on.

Since a home equity loan is secured, there’s little risk for the lender. Since unsecured personal loans come with higher risk for the lender, they also come with higher rates. And, depending upon your total outstanding mortgage balance and what the loan proceeds are used for, interest on a home equity loan may be tax deductible. Personal loan interest is not.

A home equity loan may seem like a better idea because of the low rate and potential to deduct interest, but putting your home at risk is a big deal. Plus, it can be costly and time-consuming to qualify for a home equity loan (much more so than a personal loan), and you may not qualify if your home isn’t worth enough.

Personal Loans vs. Home Equity Lines of Credit

Home equity lines of credit differ from personal loans because they’re a type of revolving debt, like credit card debt. You’re allowed to borrow up to a set maximum, but you can borrow as much or as little as you want over time and can borrow more when you pay back the loan.

And, like home equity loans, you’ll need equity in your home, your home is put at risk, and the qualifying process to get a loan can be long. However, the interest rate may be lower than the rate on a personal loan, and you may be able to deduct interest paid.

Personal Loans vs. Payday or Car Title Loans

Payday and car title loans both cater to people with bad credit. It is usually easier to get approved for them than to get approved for a personal loan, although there are personal loans for bad credit.

Payday loans are very short-term loans intended to be paid back on your next payday, rather than over years like personal loans. While you’ll have longer to repay a car title loan than a payday loan in most cases, the loan term is likely still shorter than repayment on a personal loan.

Unfortunately, both car title and payday loans have astronomically high costs due to fees. The APR is often over 300%. And with car title loans, your loan is secured or guaranteed by your car, so you risk losing your vehicle.

You want to avoid these loans at all costs and should never take them out if you could qualify for a personal loan instead.

Types of Personal Loans

Personal loans can be broadly divided into two categories: secured or unsecured personal loans.

As mentioned above, secured personal loans have collateral. You give the lender a legal interest in assets. You could guarantee a secured loan with your house, car, savings accounts, CDs, investment accounts, or other items of value. Most personal loans are secured by savings accounts or other investments, rather than homes or vehicles.

With an unsecured loan, a lender has nothing but your promise to repay. If you don’t pay and a lender wants to collect, they’d first have to get a judgment against you and then try to enforce it. While they could put a lien on your property, it’s much harder for the lender to obtain the right to force the sale of property or seize your bank account—and it usually doesn’t happen.

It’s easier to qualify for a secured personal loan, especially if you don’t have good credit. However, more lenders offer unsecured loans and the risk is lower, so you should typically try for an unsecured loan first.

How Do You Get a Personal Loan?

To obtain a personal loan, begin by shopping around. Get quotes from at least three lenders and compare interest rates, repayment timelines, fees, and other loan terms.

Once you’ve identified a lender that seems to offer a loan with favorable terms, submit an application. In most cases, you’ll be able to submit the application online, even if you’re borrowing from a traditional bank rather than an online-only lender.

When you apply, input your personal info, including your full name and Social Security number. You also need to provide other financial details the lender can use to assess how likely it is you’ll be able to repay your loan. This includes details on your current debts as well as your sources of income.

Lenders will pull your credit report to check your score, which they use as a barometer of your trustworthiness in order to decide whether to lend to you. Some lenders will also ask you to verify the info you provide, such as by submitting your tax returns or pay stubs.

After applying, you’ll receive a decision on whether your loan is approved. Sometimes, this decision is rendered instantly—especially if you’ve applied online. In other cases, you may need to wait several days.

Once you’ve been approved, you’ll be formally offered a loan and will need to sign documents promising to pay it back. You’ll receive your funds, sometimes in as little as a day or other times in around a week or more. The lender may send you a check, or money may be deposited into your bank account. Once you have it, you can do what you want with it, and you will start paying back your loan on a monthly basis.

To maximize the chances your application will be approved, look for a lender that caters to people with your income and credit score. Young people still trying to build credit may be better off with online-only lenders, especially those that target new borrowers. People with established credit may be able to get better rates from lenders that only provide loans to people with a strong credit history.

>> Read More: How to get a personal loan

Personal Loan Rates, Terms, Fees, and Limits

When comparison shopping, make sure to consider all key features of the loan, as there can be a lot of variation among lenders. Some of the key things to look at include:

• Interest rate: Interest rate refers to the percentage of the loan amount you must pay for the privilege of borrowing. It’s either fixed or variable. While variable rates can start lower, they could climb over time and cause payments to rise. There’s a wide range of personal loan interest rates, depending upon lender and credit history. Many lenders offer rates from around 6.5% to around 35.99%, but some lenders have much lower rates of around 3% or less, and others charge upwards of 100%.
• APR: APR differs from interest rate because it looks at the total cost of the loan, including fees. Comparing APRs can give you a more complete picture of total loan costs.
• Origination fees: Some lenders charge no origination fees. Others charge fees of 5% or even more. Origination fees reduce the amount you get when you borrow because the fee is usually taken out of the funds.
• Repayment terms: Many personal loans have either three-year or five-year repayment timelines. However, others have shorter or longer ones. The longer the payment term, the more interest paid but the smaller the monthly payments.
• Prepayment penalties: Some lenders charge you if you pay off your loan early.
• Funding time: If you need money quickly, look to lenders that promise funds the next business day after loan approval. Some companies, such as LendingClub, indicate it could take around a week to get funding. Traditional banks and credit unions may take longer to provide funds than online-only lenders.
• Qualifying requirements: You don’t want to apply for a loan that requires good credit if you can’t qualify, but well-qualified buyers don’t want to pick a loan targeted at bad-credit borrowers since these have higher rates.

Where Can You Get Personal Loans?

Choosing which lenders to get quotes from is also important when you’re looking for a personal loan, as you have four primary options.

Traditional Banks

Traditional banks are for-profit financial institutions. Some are big national banks, and others are small local banks. Banks tend to be more conservative in their lending standards than online lenders, so obtaining funding may not be as easy unless you’re a well-qualified borrower.

Credit Unions

Credit unions are member-owned non-profits. You may have to pay membership fees or meet certain criteria, such as living in a particular area or being part of a specific group. 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.

Online Lenders

Online lenders don’t have physical branches to maintain. They’re usually more lenient about who can borrow than physical banks, and sometimes they can offer quicker funding time than traditional financial institutions. However, you won’t have a local branch to go to for help.

Peer-to-Peer Lenders

When you get a peer-to-peer loan from sites such as LendingClub and Prosper, the loan comes from individuals who sign up to invest their own money in loans. The peer-to-peer lending company simply facilitates the process of connecting you with investors and collecting payments instead of lending you money directly. Peer-to-peer lenders can be a good option for people without great credit, because loans to riskier buyers are usually funded by investors but just at higher interest rates.

When Is a Personal Loan a Good Idea?

A personal loan is a good idea if—and only if—it’s the most affordable source of funding and you’re borrowing for something you need.

Personal loans can be a great tool for making paying debt easier. And if you have a big purchase you have to make, a personal loan could give you the funds you need at a lower interest rate than other loan types.

However, if you can get a 0% APR credit card and pay no interest on your purchase or a car loan at a lower rate to buy a vehicle, you may be better off doing so. Also, you should never borrow for things that aren’t necessities because you do have to pay interest, which makes all your purchases more expensive. This is especially a problem for people with bad credit who only qualify for personal loans at high rates.

Finally, if you can’t afford to make loan payments, you shouldn’t get a personal loan, and you shouldn’t use a personal loan to consolidate credit card debt unless you’re committed to not charging up the cards again or you’ll just end up deeper in the hole.

Bottom Line: Personal Loans Can Be a Great Way to Borrow

If you can qualify for a personal loan from a lender offering good terms and great rates, it can be a smart way to borrow. Make sure to shop around and only borrow what you need, though, and make certain you can pay off your loan on time before you sign on the dotted line.