- The Ascent
- Best Personal Loans
- How Do Personal Loans Work?
The Ascent is reader-supported: we may earn a commission from offers on this page. It’s how we make money. But our editorial integrity ensures our experts’ opinions aren’t influenced by compensation.
Personal loans are a popular way to get money to consolidate credit card debt, start a side business, or finance home improvements. In fact, you can use a personal loan to do just about anything. Personal loans are relatively easy to apply for compared to mortgages or auto loans, and approval is based on your credit history and income.
Here's how personal loans work.
A personal loan is a lump sum lent to you by a credit union, bank, or online lender. Then, you pay back the loan -- plus interest fees -- in monthly installments over a predetermined period of time. Unlike other loans for a specific type of purchase, such as a home or car loan, personal loans can be used for almost any purpose.
If you have credit card debt, a personal loan could allow you to pay off your debt through a strategy called debt consolidation. Or, if you want to do some home remodeling, pay for medical expenses, or cover pretty much any other expenses, a personal loan can allow you to finance them without having to use credit cards.
You can get a personal loan through many financial institutions, including online-based and traditional (branch-based) lenders. If you want to see some of our favorites, check out our updated list of the best personal loans.
While all personal loans are in the same general category, there are some sub-categories you should know:
A personal loan can improve your credit score -- if you make the loan payments on time.
This is especially true if the personal loan is used to consolidate credit card debt. For one thing, installment debt (loan debt) is generally considered more favorable than revolving debt (credit cards). Plus, the borrower's credit card utilization percentages will be much lower after the consolidation (you won't be very close to maxing out your credit cards). That can also provide a big boost to your score.
If you're in the process of looking for a personal loan, there are a few things things you'll need to pay attention to.
Before you shop around for a personal loan, there are a few concepts you should be familiar with in order to make the best decision for your financial situation:
The interest rate you'll pay on your personal loan can vary based on a couple factors, including your credit score and lender. Here's how to make sure you're getting the best deal.
Generally, you'll get a low interest rate if you have an excellent credit score.
If your credit score needs improvement, don't stress -- you can still get a personal loan for fair credit. These loans generally charge a higher interest rate, but the interest rate will still (usually) be lower than the interest rate on a credit card. There are also several ways to build credit fast, if you'd like to try increasing your score and improving your chances of landing a low interest rate.
It's not uncommon for a borrower to find loan offers with a difference of 8 percentage points or more on the interest rate, even when applying to the best personal lenders. This means that if you apply to a bunch of lenders, offers with APRs ranging from 8% to 16% wouldn't be unusual. What if you only apply to the 16% APR lender? You'll never know what interest rates are out there unless you apply to multiple lenders.
Most personal lenders allow you to get pre-approved, which includes checking your interest rates, in just a couple of minutes. An hour or so of shopping around for loans is easy and could save you hundreds (or even thousands) of dollars.
It can be tempting to select the longest loan repayment term possible to keep your monthly payments low. However, it's wise to consider repaying your loan in the shortest time period you can reasonably afford.
Let's say that you borrow $20,000 to fund home renovations at an 8% interest rate. Repaying the loan over a 48-month term would result in a $488.26 monthly payment, while a 72-month term would come with a $350.66 payment -- keeping an extra $137.60 in your wallet each month.
However, the longer term would result in you paying $5,248 in total interest, while the 48-month loan would have total interest charges of $3,436. By choosing to pay a little more each month, you'll save $1,812 in the long run.
We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team. The Motley Fool has a Disclosure Policy. The Author and/or The Motley Fool may have an interest in companies mentioned.
The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.
Copyright © 2018 - 2021 The Ascent. All rights reserved.
By submitting your email address, you consent to us sending you money tips along with products and services that we think might interest you. You can unsubscribe at any time. Please read our Privacy Statement and Terms & Conditions.