Applying for Your First Personal Loan? Here's What You Need to Know

Getting a personal loan can be a major financial decision. When you apply for a personal loan, you will be taking on a commitment to pay back the debt. You can use the funds for anything you want, but will have to pay back the full amount -- with interest.

You don't want to rush into this borrowing option without understanding some of the basics about how personal loans work. Here's what you need to know.

You can choose a fixed or variable interest rate

As of August, 2023, the average personal loan interest rate was 12.17%, according to the Federal Reserve Bank of St. Louis. But the rate you end up with will be based on your financial credentials, as well as whether you pick a fixed or a variable-rate loan.

A fixed-rate loan will usually have a higher starting rate. But the interest rate you start with is the one you keep -- it won't change over the entire time you are borrowing. Your monthly payments will be predictable, and you'll know from the beginning how much you're paying in total to borrow.

A variable-rate loan (also known as an adjustable-rate loan) may start out with a lower interest rate, but that could change over time. Your payment and total costs could increase. The specific details will vary, depending on how high the rate can climb and how much money you borrowed, but your costs could increase a lot if rates go up during your loan term.

You'll be subject to minimum and maximum borrowing limits

When you take out a personal loan, you can't just borrow any amount of money. There are minimum and maximum borrowing limits. For example, you might have to borrow a minimum of $1,000 or $5,000, depending on the lender. And you'll be capped at how much you can borrow. This may be a high cap -- some lenders allow you to borrow as much as $100,000.

For this reason, if you only need a fairly small amount of money, a personal loan may not be the right way to borrow. It's a bad idea to borrow more than you need, as you'll have to repay the loan and pay interest on the full amount. Do your research to ensure the lender you're considering offers loans of the size you need.

You'll get the money in a lump sum and can't borrow again without reapplying

When you get a personal loan, you decide up front how much to borrow and get that money all at once -- then start paying interest on the full amount. As you pay down your loan, you don't get to borrow more either. Say you borrowed $10,000. You get that $10,000, interest payments are calculated on the full balance, and you keep paying until the balance is $0. If you've paid off half the loan and need to borrow another $5,000, you'd have to apply again for a new personal loan.

This is different from borrowing via a credit card. If you were given a $5,000 limit on a card, you would be able to charge as much or as little as you want up to $5,000. If you charged $5,000 and then paid some or all of it back, the credit would become available for you to use again. So, if you paid your balance down to $1,000, you could borrow up to another $4,000 at any time. This gives you more flexibility.

You'll have minimum payments that ensure your loan is paid back on a set schedule

Personal loans also have their own unique payment process. Specifically, you decide up front how long your payment term will be, and then your monthly payment is calculated based on how much you've borrowed, your rate, and your desired payoff time.

Since your payoff plan allows you to know when you'll be debt-free and how much you'll spend to get there, a personal loan can provide a lot more financial certainty than other borrowing methods like credit cards -- and can be a lot cheaper.

Let's say you had a credit card with a $5,000 balance and you made 2% monthly minimum payments on it. Your starting monthly payment would be $100, but payments would go down over time since the monthly payment equals a percentage of your (continually declining) balance. Unfortunately, your payments would mostly go toward covering the interest you owe, so you'd make very slow progress with debt payoff. In fact, it could end up taking more than 30 years to pay off your debt. During that time, you'd spend around $26,568 in interest.

By contrast, if you got a $5,000 personal loan at 12.17% with a five-year repayment timeline, you'd make a monthly payment of $112 the entire time you're borrowing, would be debt-free in five years, and would pay a total of around $1,700 in interest over the life of the personal loan.

This predictability is a major advantage of personal loans. But you do need to make sure your payments are affordable. Before you take out a personal loan, compare rates and terms from several of the best personal loan lenders. You can do this online. Look at the rate, total borrowing costs, and payment time to make sure you're borrowing enough and will easily be able to pay back what you owe.

If you do this, you'll be able to find the right personal loan for your first borrowing experience.