How Do Personal Loans Work? A Guide for Beginners

Personal loans can be obtained from banks, credit unions, and online lenders, and can be used for almost anything.

Personal loans allow you to borrow a fixed amount of money and pay it back with interest over an agreed upon period of time. Your interest rate will depend on your credit score, income, and other factors.

Borrowers with a positive credit history will qualify for good credit personal loans, but there are also personal loans for people with fair credit and bad credit.

In most cases, personal loans can be used for just about anything including debt consolidation, unexpected expenses, vacations, and more.

In this guide:

• How Personal Loans Can Be Used
• Types of Personal Loans
• How Repayment Works for Personal Loans
• Personal Loan Rates, Terms, Fees, and Limits
• How to Get a Personal Loan
• Where to Get Personal Loans
• When a Personal Loan is a Good Idea
• How a Personal Loan Differs from Other Loans

How Personal Loans Can Be Used

One of the best things about personal loans is that most of the best personal loan 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,” “installment 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 and often personal loans come with lower rates than other types of debt.

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.

Types of Personal Loans

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

Secured personal loans have some sort of collateral. You could guarantee a secured loan with your house, car, savings accounts, CDs, investment accounts, or other items of value.

More personal loans, however, are unsecured. 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.

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.

>> Read More: Recourse vs. non-recourse loans

How Repayment Works for Personal Loans

When you take out a personal loan, the repayment term will be established upfront with your lender. Unlike with credit cards, you will know exactly when you’ll be debt-free.

Most personal loan lenders allow you to choose a repayment term from two to five years, but some allow for longer term lengths. 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. If you have a variable rate loan, on the other hand, your interest rate and monthly payment can change.

If you later become eligible for a loan with a lower interest rate, you can refinance your personal loan to save on interest costs.

>> Read More: How to avoid defaulting on a loan

Personal Loan Rates, Terms, Fees, and Limits

When comparison shopping, make sure to consider all key features of the loan, especially fees, 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 borrowing the money. Rates are either fixed (remain constant) or variable (change with the markets). Personal loan interest rates vary depending upon the lender and your credit score, but typically range from around 4.99% to around 35.99%.
• APR: APRs differ from interest rates in that they 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. Depending on your timeline, you can find both long-term loans or short-term loans.
• 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: Lenders typically offer loans targeted at groups of people based on their credit scores. If you have good credit, you don’t want to apply for a personal loan designed for someone with bad credit. Similarly, if you have bad credit, you would likely be wasting your time applying for a personal loan for someone with good credit.
• Loan amount: The amount you can borrow varies by lender, so you’ll need to make sure the lender you choose can cover the entire cost of your project. You can check out our guide to personal loan limits to see how much you can borrow from certain lenders.

How to Get a Personal Loan

1) Shop Around for a Lender

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.

You can compare our top choices on our Best Personal Loans page.

2) Submit an Application

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.

You will need to submit 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, including details on your current debt as well as your of income.

You may want to consider applying with a co-applicant or a cosigner to improve your chances of being approved and receiving the best rates.

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.

3) Review the Loan Offer (If Approved)

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.

4) Receive Your Funds & Start Repayment

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.

>> Read More: How to Get a Personal Loan

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. You can compare bank loan options here.

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.

>> Read More: How to avoid personal loan scams

When is a Personal Loan a Good Idea?

Consider if it’s the Cheapest Option

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 to make 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.

Consider the Total Loan Cost

You should avoid borrowing 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.

Before taking out a personal loan, understand how much it will cost you including interest. You can use our Personal Loan Calculator to see for yourself.

Figure Out if You Can Afford Repayment

Finally, if you can’t afford to make loan payments, you shouldn’t get a personal loan. Also, you shouldn’t use a personal loan to consolidate credit card debt if you’re just doing it so you can start maxing out the cards again.

>> Read more: How Many Personal Loans Can You Have at Once?

How a Personal Loan is 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

Borrowing Limits

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.

Making Payments

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.

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.

Interest Charges

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 card. 

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.

Personal Loans vs. Home Equity Loans

Loan Amounts & Interest Types

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.

Repayment

Both also have a set repayment timeline, and monthly payments are determined based on the principal and interest needed to pay the loan on time. However, the big difference is that a home equity loan uses your home as collateral while a personal loan is usually unsecured.

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.

Deciding Between the Two

A home equity loan may seem like a better idea because of the low rate and potential to deduct interest from your taxes, 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.

>> Read More: Best Home Equity Loans

Personal Loans vs. Home Equity Lines of Credit

Home equity lines of credit (HELOCs) differ from personal loans because they’re a type of revolving debt, like credit cards. 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.

>> Read More: Best HELOC Rates & Lenders

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.

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.