Personal Loans Made Easy
Matt is a Certified Financial Planner® and investment advisor based in Columbia, South Carolina. He writes personal finance and investment advice, and in 2017 he received the SABEW Best in Business Award.
We are committed to full transparency in our mission to make the world smarter, happier, & richer. Offers on The Ascent may be from our partners - it's how we make money - and we have not reviewed all available products and offers. That transparency to you is core to our editorial integrity, which isn’t influenced by compensation.
Personal loans are a popular way to get money to consolidate credit card debt, start a side business, or do some 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.
However, before you apply for one, it’s important that you understand what a personal loan is and how it works.
What is a personal loan and how does it work?
A personal loan is money lent by a bank or credit union to a borrower in a lump sum. The loan plus interest fees, which are determined by your credit score, are paid back in monthly installments over a predetermined period of time, called the loan term. Unlike other loans meant to be used for a specific type of purchase, such as a home or car loan, personal loans can be used for a variety of purposes.
A personal loan has a few specific characteristics that separate it from other loan products, such as auto loans and mortgages:
- Personal loans are unsecured loans. That means, unlike mortgage loans, which are backed by the homes they’re used to buy, personal loans aren't backed by any type of collateral, even if they are used to purchase a valuable asset.
- Personal loans have a fixed repayment term. Unlike credit cards, there's a clearly defined date when you'll finish paying off a personal loan. Most (but not all) personal loans also have fixed interest rates, which results in a set monthly payment amount.
- Personal loans aren't made for a specific purpose. A lender may ask how you plan to use the proceeds (credit card consolidation, for example), but once the loan is made you can use the proceeds for virtually any purpose. That said, some lenders may have certain restrictions, so be sure to read the fine print if you plan to use a personal loan in an unusual manner.
Important personal loan concepts to know
Before you start shopping around for a personal loan, there are a few concepts you should be familiar with, in order to be in a position 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 is going to cost 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 any 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 remember that shorter loan terms do mean bigger monthly payments. You never 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, as of early 2020. Take out enough to cover the cost of your purchase, 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 that a lender can charge you if you repay your loan early, or before the loan term ends. You should 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, but they aren't unheard of either.
Reasons to get a personal loan
There are a few reasons why getting a personal loan could be a smart idea. For example, if you have credit card debt, a personal loan could allow you to pay off your debt and consolidate several smaller balances into one fixed monthly payment. Or, if you want to do some home remodeling, pay for medical expenses, or cover pretty much any other expenses you may have, a personal loan can allow you to finance these things without having to max out credit cards.
Personal loan interest rates
The higher your credit score, the lower your interest rate. Most traditional banks require good or excellent credit in order to qualify for a personal loan. Thanks to online lenders, there are options for people with fair and bad credit who need personal loans as well. However, these loans will come with high interest rates, so they might not be worth the cost.
Lenders generally publish a range of annual percentage rates for their personal loan products. It's important to mention that for each lender, the lower end of the APR range is generally reserved for borrowers with excellent credit scores (think 760 FICO® Scores or higher). However, many borrowers (even those with less-than-ideal credit) can obtain personal loans with significantly lower interest rates than they're paying on credit cards.
Types of personal loans
While all personal loans are in the same overall 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. To be clear, if your credit is truly bad, you probably won't qualify for a personal loan, but borrowers with fair scores can.
- Peer-to-peer (P2P) loans -- As opposed to the traditional "bank loans money" idea, the peer-to-peer lender has emerged in recent years. Instead of a bank loaning money, a P2P lender will source funds for its loans from everyday investors.
Where can you get a personal loan?
The short answer is that you can get a personal loan through many financial institutions, both 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, most of which will allow you to check your APR and loan terms without conducting a hard credit pull.
How much time do you need to repay your loan?
It can be tempting to select the longest loan repayment term possible in order to keep your monthly payments low. However, I'd strongly advise you 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 yourself $1,812 in the long run.
It's important to shop around for the best rate
Applying for one personal loan and accepting the lender's offer without doing any comparison shopping is one of the biggest "rookie mistakes" you can make, and it's easy to see why people new to personal loans make it often. After all, it may seem logical that any particular borrower could expect roughly the same terms from whatever lender they apply to. However, this is 100% untrue.
In fact, it's not uncommon for a borrower to find loan offers with a difference of 8 percentage points or more on their loan's 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. Imagine if you had simply applied to the 16% APR lender and accepted that loan agreement.
Furthermore, there's really no good reason not to shop around. Most personal lenders allow you to check your personalized loan offers and get pre-approved, including checking your interest rates, in just a couple of minutes and without a hard credit pull that could hurt your credit score. In other words, an hour or so of shopping around for loans could potentially save you hundreds or even thousands of dollars on a personal loan.
How does a personal loan impact your credit score?
Generally speaking, a personal loan is typically a positive catalyst for the borrower's credit score, assuming they 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 (loans) 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, which can provide a big boost.
Is a personal loan right for you?
Like any financial product, a personal loan isn't perfect for every situation. For example, if you have the ability and desire to pay off the loan within a couple years, you might be better off using a 0% APR balance transfer offer.
However, if you're looking to consolidate credit card debt, finance home repairs without borrowing against your home equity, or pay for a large purchase, a personal loan is certainly an option that's worth exploring.