How Do Personal Loans Work? Understanding the Basics

Personal loans come in all shapes and sizes. From the traditional path through major banks to micro loan websites and peer-to-peer lenders, nowadays the options to secure a personal loan are greater than ever.

Before you start searching for a lender, it’s crucial you take the time to understand the basics of how personal loans work.

Knowing how to pick the right lender, the right loan, and what you’ll need to prepare for before applying is critical to ensure the entire process goes smoothly. Many people have flippantly gone searching for personal loans without proper understanding who end up in financial ruin.

Personal loans, in general, are highly customizable products, and the more you understand about them, the better off you’ll be in finding the right lender and the right loan to boost your financial well being.

What Exactly Is a Personal Loan?

Simply put, a personal loan is money you borrow from a lender at a price. This typically means you’ll secure a few thousand dollars, and will have to pay it back within 2-5 years with a set interest rate of around 5.99% to 35.99%.

The price you pay for your personal loan is called an annual percentage rate (APR).

Personal loans can either be “secured” or “unsecured”.

Secured loans are loans that require you to put up a form of collateral to receive the loan. For instance, if you want a $20,000 loan, you may have to put your $10,000 car down as collateral. If, for some reason, you aren’t able to make payments and stop making them entirely, this will give the lender the legal right to seize your vehicle.

Unsecured loans simply mean you don’t need to put up collateral. Secured loans often come with lower fees and better rates since there is less risk for the lender that you will default on your payments.

What Makes Personal Loans Different From Other Loans?

Personal loans usually have lower interest rates compared to credit cards. This means if you have multiple credit cards with high interest rates around 20%, you may be better off taking out a personal loan at 10% interest to pay down your credit card debt. This is called debt consolidation and is one of the most common reasons consumers take out personal loans.

Compared to other types of loans like a mortgage, student loan, or car loan, you aren’t typically restricted in how you spend the money from a personal loan.

Car loans and mortgages often require you to put down collateral. However, most personal loans won’t be secured, but unsecured so you won’t likely need to put down collateral.

Personal loans are also limited in how much you can borrow. Typically, personal loans cap out around $100,000.

How Do You Pick a Lender?

When you apply for a loan, you should always look for the best possible APR and best possible terms. However, this isn’t always easy if you have a fair or poor credit score and you may have to settle for less than best.

In order to figure out which lender you should choose, you should first figure out the purpose for your loan, what amount you need, and if you need to pay it off quickly or slowly.

You should already know what your credit score is and your overall financial situation. Once you’ve determined these steps, then it’s much easier to figure out what kind of lender matches your goals and your financial picture.

You can go through a direct lender like Marcus or Upgrade, or you could use a marketplace lender, like LendingTree, who partners with multiple direct lenders. Marketplace lenders will show you multiple offers from different lenders when you apply.

Another type of lender is a peer-to-peer lender, like LendingClub. This type of lender lets you invest in a loan and also take out a loan at the same time. This can help you make money off your loan to help pay your loan from the same source.

Most Common Purposes for Personal Loans

While you can typically spend your personal loan on whatever you want, making sense of the word “personal”, there are a few common reasons people will take out a personal loan.

Personal loans can be used in almost any situation. However, here are the most common reasons people take advantage of a personal loan:

● Debt consolidation

● Refinancing

● Home improvements

● Car or boat purchases

● Weddings

● Vacations

● Medical Expenses

● Moving Expenses

You should be cautious when considering taking out a loan for a wedding or a vacation. Don’t borrow more than you’ll be able to pay back quickly. These types of purposes aren’t exactly going to pay you back over time.

However, taking out a personal loan for a home renovation can be a smart way to improve the value of your house prior to selling it. If you invest $10,000 into your home, and it increases the value of your home by $17,000 then that’s a smart investment.

You should take advantage of online loan calculators to figure out just how much your monthly payments would be by taking out a loan based on the term and APR.

The Basics of Personal Loan Rates

Knowing how personal loan interest rates work is critical to understanding the impact of a loan and how much it will actually cost you. Personal loans aren’t free money. This money comes at a cost that you’ll have to pay back.

The interest rate is the cost of borrowing money from a lender. This rate can vary depending on your financial situation including your credit rating.

Some personal loans have variable interest rates which means they can change over time depending on the market.

However, most personal loans come with a fixed interest rate which means it will stay the same for the entire duration of the loan so you’ll know exactly how much you will pay every month.

What Exactly is an APR?

An APR is an annual percentage rate. This is the amount you will pay to borrow the money. It’s the price of the loan. This includes interest charges and additional fees.

Some lenders may issue loans at lower interest rates than competitors, but your actual APR may be higher if they charge different fees like an origination fee (which can be between 0%-5% in most cases).

Many personal loans range between 5.99% to 35.99% APR.

Here are average APRs borrowers have received based on their FICO credit score:

● 720+: 12.5% APR

● 690-719: 15.5% APR

● 630-689: 19.9% APR

● 629 and below: 32% APR

Short Term Loans vs. Long Term Loans

One of the most important details about your loan is the term of repayment. Personal loans are either short-term or long-term, which can range from 6 months to 7 years.

While some lenders will offer a variety of term lengths, others will only offer one or two options.

3 Common Personal Loan Types

Loans can vary in purpose, but they can also vary in type. While loans can be unsecured or secured, they can also vary as installment loans, revolving loans, or lines of credit.

Installment Loan

Installment loans are the most common type of loan. With this loan, you receive a lump sum of money up front which is then repaid over time at set intervals (typically once a month).

Payments could fluctuate depending on whether you have a fixed-rate or variable-rate loan. The longer the term is, the lower the monthly payments are and the higher the interest rate.

Revolving Loan

Revolving loans include loans that you can pull on that let you pay the loan in full right away or pay back over time. The most common example of a revolving loan is a credit card.

Line of Credit

A line of credit is technically a type of revolving loan. However, with lines of credit, they’re typically larger amounts than credit cards and have lower interest rates. You can borrow all the money up front or withdraw it over time. Payment schedules are also flexible as you can pay it all back at once or over time.

How Can I Qualify for a Personal Loan?

Before you apply for a personal loan, you should first check your credit score, which you can do online for free. This will give you a general idea of what type of fees you’ll be charged, and what lender companies you’ll be able to apply to. If your credit score is low, then it may be best to wait to take out a personal loan until your credit is built up.

Before applying to a lender, you’ll want to get all necessary documents together. This will likely include your driver’s license, social security number, pay stubs, proof of income, proof of employment, and more.

How High Should My Credit Be to Apply for a Personal Loan?

Your credit score carries the most weight when it comes to being approved for a loan or not. Generally speaking, you should aim to have a credit score of at least 660 before applying for a personal loan.

However, you may still qualify for a personal loan if your credit score is under 660.

Some online lenders and peer-to-peer lenders are more lenient when it comes to lower scores. However, you will likely qualify for a lower loan, a shorter term, and a higher interest rate if you are approved with poor or fair credit.

You also will likely need to provide even more documentation and you may have to put down collateral to secure a loan with a lower score.

It’s always best to check with a lender to see what scores they typically approve before you go through the whole process.

How Do I Apply for a Personal Loan?

Nowadays, applying for a personal loan is a piece of cake. Not too long ago, borrowers had to take the traditional route and go through major banks through extensive processes which could take several hours over several days and in multiple meetings.

In the modern lending world, applying for a personal loan can be done in a few minutes from the comfort of your home with your fingers on your smartphone or computer.

While loan application processes vary from lender to lender, they typically require a few basic steps.

Online loan providers will usually request basic information like your address, date of birth, monthly income, current debts, and monthly income.

Lenders will usually do a soft credit check to determine how good your credit is before pre-approving you for a loan. This soft credit check won’t negatively impact your credit score.

Then, once you’ve been pre-approved, you’ll be notified of your loan options, terms, and rates you qualify for. Then, it’s up to you to accept or decline the loan agreement. Upon agreement, the lender will perform a hard credit check and you will have your funds in your account in a few days.

What Are the Risks in Using a Personal Loan?

The final thing you should consider before applying for a loan are the risks. While this isn’t the fun part, it’s definitely necessary to ensure you don’t run into major issues later on.

If you receive an unsecured personal loan, you’ll probably have to pay high interest rates higher than 10% that can weigh heavy on your wallet. You may be tempted to put something into the agreement for collateral like your car or your house since you’ll likely be given a better term and better interest rate.

However, if you aren’t able to make payments later on, you need to understand that the lender will be able to legally seize your home or car. This shouldn’t be done lightly.

If you choose an unsecured loan, you need to understand just how much you’ll be paying towards it every month.

Always check if there are any additional fees like an origination fee, prepayment fees, late fees, or processing fees.

Make sure you always read the fine print on your loan agreement. You could run into trouble later on if you didn’t realize there actually were hidden fees.

In the end, if you understand the risks, read the fine print, and know you’ll be able to pay back your loan with due diligence, then you’ll be prepared to take out your first personal loan, which can help you renovate your home, pay off some unexpected medical bills, or consolidate your credit card debt into one easy payment.

Make lenders compete
to get a low rate

Answer few questions and compare rates from multiple lenders

Compare Rates