How Do Personal Loans Work?

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.

What is a personal loan and how does it 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.

Where can you get a personal loan?

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.

Types of personal loans

While all personal loans are in the same general category, there are some sub-categories you should know:

Personal loans for good credit -- Many personal lenders focus specifically on "prime" borrowers -- that is, consumers with strong credit histories.
Personal loans for bad credit -- There are some companies that have personal loan products designed for borrowers with sub-optimal credit.
Personal loans for debt consolidation -- These loans allow you to combine (or "consolidate") multiple debt payments (credit cards, auto loan, etc.) into one simple payment. A debt consolidation loan usually has a lower interest rate, too, which means you'll probably have a lower monthly payment.
Medical loans -- A medical loan is generally used to pay for healthcare costs.
Renovation loans -- These types of loans can help fund home improvements, like installing a pool, redoing a bathroom or kitchen, or finishing a basement.
Coronavirus hardship loans -- If your income was cut by COVID-19, you may qualify for a coronavirus hardship loan. These loans are smaller and meant to help you pay the bills during a short period of unemployment.

How does a personal loan impact your credit score?

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.

How to choose a personal loan

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.

Understand important personal loan concepts

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:

Credit and income requirements. Read through each lender's minimum credit score requirements to make sure you qualify before applying. Some lenders also have income requirements.
Interest rate. This is arguably the most important feature to pay attention to, as it's the main determinant of how much your loan costs you over time. You want to secure the lowest interest rate possible. Pay particular attention to annual percentage rates, or APRs, which include the loan's interest rate as well as origination charges (if applicable).
Loan term. Your loan term is how long you have to pay off the loan. You want to pay off your loan as quickly as possible to save money on interest. But shorter loan terms also mean bigger monthly payments. You never, of course, want to accept a loan with a monthly payment you can't afford.
Loan amount. Personal loans can range from $1,000 to $100,000. Take out enough to cover what you need, but never borrow more than you need.
Origination fee. Although it isn't very common, some lenders charge an origination fee. This is typically a percentage of the total loan amount. Look for loans with minimal or no origination fee.
Prepayment penalty. A prepayment penalty is a fee a lender can charge if you repay your loan before the loan term ends. Avoid loans with prepayment penalties, because it's always best to pay off your loan ahead of schedule when you can. The good news is that prepayment penalties are not common in the personal loan industry.
Secured vs. unsecured loans. Most personal loans don't require collateral -- these are known as "unsecured" loans. This means the lender can't take your car or home if you can't pay the loan. But if your credit is poor, you might not qualify for an unsecured loan. In that case, you may have to offer collateral (such as money in a savings account or CD) to qualify for a loan.

Get the best interest rate

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.

Improve your credit score

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.

Compare multiple lenders

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.

Know how much time you need to repay the loan

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.