What is a personal loan?
Key takeaways
- A personal loan is money you can borrow in a lump sum with a fixed payment to finance large purchases, consolidate debt, invest in yourself or cover emergency expenses.
- Interest rates, monthly payments and repayment terms vary based on creditworthiness, income and other factors.
- You'll get the best loan terms if you improve your credit score and reduce your debt-to-income ratio before applying.
A personal loan is a type of installment loan with a fixed rate and monthly payment. You receive a lump sum after approval and can use your loan for nearly any purpose. People often choose personal loans because they feature lower fixed interest rates than credit cards, and you can get the funds quickly.
You can get a personal loan from online lenders, banks and credit unions.
How do personal loans work?
A personal loan works a lot like an auto loan. You borrow money from a lender and pay it back in equal payments over a term of up to seven years. However, unlike a car loan, most personal loans are unsecured. You don’t need any collateral for approval.
Because personal loans aren’t secured, you qualify primarily through your credit score and your debt-to-income ratio.
Lenders advertise loan amounts between $1,000 and $100,000. Average personal loan rates currently range from about 8 percent to 36 percent. You will need excellent credit and a high income to qualify for the lowest rates and high loan amounst.
Some lenders offer bad credit personal loans. These will have less favorable terms.
The application process can take anywhere from a few hours to several days. Once you’re approved, the lender will disburse your loan funds into your bank account.
Then you begin to repay your loan. Lenders generally report account activity to the credit bureau. Making on-time payments is crucial to building and maintaining a positive credit history.
How personal loan rates are determined
Lenders’ minimum and maximum annual percentage rates (APRs) are influenced by the federal funds rate, among other factors. These rates change based on the market. But once you receive a rate, it is fixed for the loan’s term.
Your interest rate is based primarily on your credit score. If you have an excellent score, you may qualify for a lender’s lowest rates. The best rates typically go to people with credit scores above 800.
Lenders may also consider additional factors, including:
- Income: Lenders like to see that you have a steady and reliable income source, like a salary or full-time hourly job, to prove you can make your monthly payments.
- Payment history: Lenders typically reward you with a lower interest rate if you’ve managed your credit without late payments.
- Debt-to-income ratio: If a high percentage of your income is already used to pay debts, lenders may charge you a higher rate to cover the risk you might not be able to afford a new personal loan.
- Loan term: You may be offered a lower APR for a shorter term or charge a higher rate for longer terms. The lender knows the longer you have a loan, the more likely something could change in your finances that could make the payment unaffordable.
Common features of personal loans
Most personal loans have similar features, regardless of the lender.
- Fixed interest rates: Personal loan lenders charge fixed interest rates based primarily on your creditworthiness and debt-to-income ratio. Because interest rates are fixed, the APR on a personal loan won’t change over time.
- Stable monthly payments: A fixed rate gives you a predictable monthly payment, making personal loans a popular choice for consolidating debt.
- Long loan terms: Most lenders offer repayment terms of one to seven years. This makes it easy to calculate your payment and see how much interest you will pay over time.
- Origination fees: You may pay an origination fee of up to 12 percent for a personal loan. The fee is deducted from your funds when you finalize your application, reducing the amount you receive from the lender.
Common uses of personal loans
Personal loan proceeds can be used for almost any legal purpose. Some lenders may restrict you to only unsecured options, while others may allow you to secure a personal loan with an asset, like a car or boat. Overall, personal loan funds give you the cash to use for a variety of different purposes.
If you’re tired of seeing your credit card balances barely budge when making minimum payments, a personal loan can help you reduce your balances much faster. Just make sure your budget is ready for a fixed monthly payment and you have consistent income to make the payments. Your credit scores may improve quickly after paying off revolving credit balances — as long as you don’t turn around and start using credit cards again.
Common uses include:
- Debt consolidation: Debt consolidation loans may help you save money on interest by combining high-interest credit card or other debt into a single personal loan.
- Paying for emergency expenses: Same- or next-day funding times make emergency personal loans a great option for financial emergencies, such as surprise medical bills, a leaky roof or even funeral expenses.
- Home improvement projects: Unsecured personal loans are approved faster than home equity products and don’t require putting your home up for collateral. Using a personal loan to increase the value of your home is a way to use a personal loan to make money.
- Financing life’s big events: Major life milestones like financing a wedding or dream vacation often come with high price tags. A personal loan is also a good alternative to using credit cards because of their generally lower cost. But remember that you may be paying off the bill for years to come.
- Investing in yourself: A personal loan may be a good tool to increase your value as an employee. You might pursue a workplace certification or attend a career-boosting seminar. However, lenders may not allow you to use personal loan funds to pay for college tuition.
- Refinancing an existing loan: If you took out a bad credit loan and your scores have improved, you can look into refinancing an existing loan for a lower rate or monthly payment.
Personal loan mistakes to avoid
Knowing the six common mistakes people make when taking out a personal loan can help you avoid them.
- Getting a longer loan term than necessary: The longer the loan term, the more interest you’ll have to pay during the life of your loan. Before taking on debt, use a personal loan repayment calculator to help budget.
- Not shopping around for the best offers: Gathering quotes from multiple lenders can help you spot the best deal and potentially save you interest. Compare interest rates, fees and lender reputation before applying for the loan.
- Not considering your credit score: Your credit score is a big factor in determining your eligibility for the loan as well as the interest rate. Some lenders may also charge higher origination fees for less creditworthy borrowers. Before applying, know what your score is so that you know what to expect in terms of costs.
- Overlooking fees and penalties: Be on the lookout for hidden fees and penalties by reading the lender’s terms and conditions page so you don’t end up with less cash than you need for your financial goals.
- Not reading the fine print: Before you sign and finalize the loan agreements, review the terms to make sure they’re what you agreed to.
- Falling behind on payments. Make loan payments on time to avoid defaulting on your personal loan and causing a negative hit to your credit.
One other mistake to avoid is committing to a personal loan if your income is unstable. If you earn the bulk of your income from variable income like commissions or tips, a fixed payment may be tough to handle if you have a low earnings month. Also, don’t choose a short term unless you’re sure you can make the payments. For example, if you depend on a spouse’s income to cover half your expenses, a short-term personal loan payment could become a burden if your spouse is laid off.
The bottom line
If you need to borrow money and prefer the stability of a fixed monthly payment, a personal loan could be exactly what you need. To get the best loan rates and terms, improve your credit and pay down existing debt to get the most competitive loan rates and terms.
It’s also important to shop around and compare personal loan rates with multiple lenders in the personal loan space, including companies that offer online loans.
Frequently asked questions
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Personal loans are great for short- to medium-term borrowing at rates that are typically lower than credit cards. They can be a good option if you have good credit and a specific financial goal in mind.
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No. Personal loans require documented proof you have the credit profile and income to repay them. Although they’re easier to qualify for than home equity loans or other secured loans, you still need to show the lender you have the means to pay the loan back.
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Personal loans are better than credit cards if you want a set monthly payment and need all of your funds at once. They also feature fixed rates, so you don’t have to worry about your payment changing like they do with most variable-rate credit cards.
Credit cards may be a better personal loan alternative if you need the flexibility to draw money as needed, pay it off and re-use it. Credit cards may also offer rewards or cash-back options that personal loans don’t.Ultimately, the best credit product for you will depend on your money habits and what you need the funds for.
Up next
Should I get a personal loan? Here are the pros and cons
8 types of personal loans and their uses — plus 5 to avoid
What is the average personal loan interest rate?
How to calculate interest on a loan
How to calculate loan payments and costs
How to get a personal loan in 9 steps
