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Personal Loans

How Do Personal Loans Work? A Guide for Beginners

Personal loans are versatile, allowing you to use your funds for almost anything you want. They’re often 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.

What is a personal loan? 

A personal loan is a type of installment loan you can use for a variety of purposes. When you’re approved for a personal loan, you’ll get your proceeds in a lump sum, minus 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.

Types of personal loans

Personal loans fall into two general categories: unsecured and secured. Here are the main differences:

Unsecured 🔓Secured 🔒
Most common Less common
No collateral requiredCollateral required
Available to borrowers with a range of credit scoresCan be easier to qualify for a secured personal loan if you don’t have good credit. 
Tend to have higher interest rates, but lower rates are available with excellent creditTypically have lower interest rates than unsecured
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

For a more detailed breakdown, check out our resource on personal loan types.

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

Most lenders have limitations on how you can use your loan funds. Common prohibited uses include:

  • Education-related expenses, including consolidating student loan debt
  • Investments
  • Business expenses
  • Home down payment (this restriction often 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 at a disadvantage 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 work the same regardless of the lender, but the exact terms can vary. 

Lender typeWhat to know
BankTend to have more conservative lending standards than online lenders (more stringent credit requirements); may also charge higher interest rates and fees
Credit unionMember-owned, not-for-profit, return profits to members through lower rates and fees; qualifying for a loan requires becoming a member
OnlineNo branches can allow lenders to offer lower rates & fees; more likely to loan to borrowers with poor credit; same-day funding may be available
Peer-to-peerLoans come from individuals who agree to invest their money in loans; companies facilitate matching borrowers with individual lenders and collecting payments; credit req’s may be less stringent

How does a personal loan work?

Getting a personal loan can vary by lender, but these general guidelines can help you know what to expect.

1. Shop around and compare interest rates

Every lender has its own interest rates, fees, repayment terms, and credit requirements, so it’s wise to compare personal loans from multiple lenders before you apply.

Many lenders allow borrowers to prequalify with a soft credit check, so you don’t need to worry about the rate-shopping process hurting your credit score. Try to get rate quotes from at least three lenders to get an idea of what you qualify for.

2. Choose a lender

Once you’ve prequalified with a handful of lenders, select the one 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 apply.

3. Submit an application

You can often 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 takes a few minutes to complete and often 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 will 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 get 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, review the lender’s loan offer—it may not be the same as your initial quote from the prequalification process. Look out for fees that could reduce your amount.

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

You can also request a paper check or, if you’re using the loan to consolidate other debt, have the lender issue payment to your creditors.

5. Get your funds and start repayment

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

If you opt for a check or ask the lender to pay off debt on your behalf, it can take several days. Once you getthe 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 miss any. Some lenders may discount your interest rate for being on autopay. The typical discount is 0.25%.

Personal loan rates, terms, fees, and limits

Review the following details when comparing personal loans. Many of these features affect your monthly payment and how much interest you’ll pay over the life of the loan:

Interest rate

The interest rate on a personal loan is the primary cost of borrowing and is 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, the APR is the most important number. For instance, if a personal loan charges an origination fee, the APR will be higher than the interest rate.

Origination fees

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

Your repayment term is the time you have to repay the loan. You’ll choose your 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: Loans from the top personal loan companies often have repayment terms ranging from one to seven years, but some lenders offer more flexibility. Some lenders may only offer 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 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 review the loan agreement to avoid surprises.

Funding time

Funding time is how long it takes to get your loan money from the lender.

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

Eligibility 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 your interest rate and fees. 

What to look for: Lenders typically consider three factors:

FactorWhat to know
Credit scoreMost personal loan lenders require a credit score in the 600s, but some specialize in working with borrowers in the 500s or lower
Credit historyLenders consider debts, payment history, and negative items, such as bankruptcy or foreclosures
Debt-to-income ratio (DTI)Lenders will add up your monthly debt payments and divide the sum by your gross monthly income to determine your DTI. Many lenders prefer a DTI of 40% or less, but some may go higher

Before applying for a personal loan, check your credit score using a free service to gauge your approval odds.

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 

Personal loans can be a terrific way to get the financing you need, but be sure to consider the alternatives to ensure you pick the one that’s best for you.

Here’s a quick summary.

Funding optionBest for
Personal loanBorrowers with good or excellent credit who want a fixed payment and term
Credit cardPeople who want a revolving line of credit for everyday purchases
Home equity loan Homeowners with significant home equity who want a lump-sum disbursement
Home equity line of creditHomeowners with significant home equity who want a revolving line of credit
Payday loanBorrowers with no other way to access 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 calculated based on your balance from the previous month. 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.

Some personal loans charge higher interest rates than credit cards, but 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 may 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 might 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 often 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 need 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. 

Most HELOC interest rates are 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. 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 poor credit because you don’t need to undergo a credit check to get approved. However, these small-dollar loans tend to 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. Here are questions to ask yourself to determine whether to proceed.

Is it the most cost-effective option?

Consider whether you can achieve your goal more cheaply. 

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 save you money. Take your time to compare 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 essential 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, you could risk defaulting on your payments. 

How do I choose the best personal loan?

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

1. Shop around

Shopping around and comparing interest rates, fees, repayment terms, and other features is one of the most important actions you can take 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.

Get quotes from at least three lenders tocompare terms. You can compare our top choices on our best personal loans page.

2. 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.

After providing basic information about yourself, you can see potential interest rates, loan amounts, fees, repayment terms, and monthly payments. In most cases, the process takes just 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.

3. 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.

Not all lenders allow cosigners and co-applicants. To avoid wasting your time, ensure you know the lender’s policy before you start the application process. 

Also, if you add someone to your application, they’ll be equally responsible for paying the debt, and the loan will show up on 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, it is possible to have more than one personal loan at once. However, your options may be limited if your personal loan has a high monthly payment relative to your gross income or your DTI is high. 

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How does having a personal loan affect my credit?

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

  • Credit inquiry: When you apply for a loan, the hard credit inquiry may knock a few points off your credit score.
  • New account: Opening a new credit account will reduce your average age of accounts, which can lower your credit score. Also, the new debt could affect your credit.
  • Payments: Missing a payment by 30 days or more could harm your credit. 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 how a personal loan can affect your score. However, using credit responsibly will help improve your credit history in the long run.