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Ashley Maready
At some point in your life, you will need to borrow money. Whether it's to pay for unexpected expenses, fund a home renovation, or consolidate debt, a personal loan can be a great option.
You may be wondering: What is a personal loan? A personal loan is a lump sum of money that you borrow and pay back in monthly installments at a fixed rate of interest.
However, not all personal loans are created equal, and it's important to understand the different types of personal loans available and their respective pros and cons. Personal loans fall into two categories: unsecured loans and secured loans.
Secured loans are backed by collateral such as property, cars, and other assets. Unsecured loans do not require collateral. For both types of loans, your credit score is an important factor in the interest rate and loan terms you receive. Understanding how these personal loans work can help you make a smarter decision. Let's take a closer look at different personal loan options.
Unsecured personal loans
An unsecured personal loan is not secured by any collateral. As a result, unsecured loans are a higher risk for financial lenders. Consequently, these loans typically have higher interest rates than secured personal loans. However, unsecured loans can be useful for those who do not have collateral to pledge, as well as for those who don't want to risk losing their property if they can't repay the loan.
Lenders typically require a higher credit score to qualify for an unsecured loan. Common examples of unsecured loans are credit cards and payday loans. Here are more types of unsecured loans.
Home improvement loan
Home improvement loans pay for home renovations. You might borrow to pay for a kitchen or bathroom remodel, or home repairs.
Best for people looking to add value to their home
Home improvement projects can increase your enjoyment of your home and also add value when you sell your home. According to the Zillow Group Consumer Housing Trends Report 2022, 71% of homeowners make at least one home improvement (e.g. painting, redecorating, kitchen improvement, new appliances, replacing/repairing flooring, etc) when preparing to sell their home.
New research also reveals that the average homeowner is ready to invest a substantial $42,000 in revamping their home's appearance.
Debt consolidation loan
Debt consolidation loans are used to pay off multiple debts. These could be balances on credit cards, personal loans, or other types of debt.
Best for people looking to simplify their finances and pay off loans faster
As the name suggests, debt consolidation loans enable you to combine multiple high interest debts into a single loan, often with a lower APR and a fixed rate. This type of personal loan can help simplify your finances, as you'll only need to make one monthly payment.
It can also reduce the amount of interest you'll pay over time. However, be cautious about taking on too much debt, as you could end up in a worse financial position than before.
Peer-to-peer lending
Peer-to-peer (P2P) loans are loans from other individuals. Financial institutions are cut out as the middleman. Many websites facilitate P2P loans between individual borrowers and lenders.
Need a loan? Check out The Ascent's guide to the best peer-to-peer lenders.
Best for people looking for alternative sources of loans
P2P lending is also known as "social lending" or "crowd lending," and is a relatively new alternative source of loans. P2P is best for people who want to avoid the red tape of large financial institutions and get access to funds relatively quickly.
P2P websites match lenders with potential borrowers. Borrowers apply for a personal loan on the website and investors can select who they want to lend money to. Borrowers can receive P2P loans from multiple investors.
Payday loans
Payday loans are short-term loans designed to cover a financial shortfall until your next paycheck. These loans are notorious for their sky-high interest rates and fees and can quickly spiral out of control if you can't repay the loan on time.
Best for people who need emergency cash and don't have other options
Payday loans are generally for $500 or less, and repayment is due on your next payday. Currently, 37 states regulate payday loans due to high costs. Depending on state laws, people can get payday loans online or through a storefront lender.
A typical two-week payday loan can have annual percentage rates (APR) as high as 400%. In comparison, credit card APRs can range from 12% to 30%. While payday loans may seem like a quick fix, they should be avoided at all costs, as there are almost always better borrowing options available.
RELATED: Payday Loan Alternatives
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Secured personal loans
A secured personal loan is backed by collateral. Examples include auto loans and home mortgages. Because of the reduced risk to the lender, secured personal loans offer lower interest rates and can be easier to qualify for than unsecured personal loans.
However, there is a downside: If you fail to repay your secured personal loan, the lender can repossess the collateral to recoup its losses. Therefore, it's essential to ensure that you can repay this type of loan before taking one out. Here are a few common types of secured loans.
Credit builder loans
Credit builder loans are primarily designed to help people improve their credit scores. With this type of loan, the borrower will put cash into an account to be used as collateral. The borrower will borrow against the collateral and pays the principal and interest back to the lender. The lender then reports the payment to the credit bureaus.
Best for people who have little to no credit history
A good credit score is essential to get the best interest rates and loan approval. Those who have bad credit and need to establish credit history can use credit builder loans to help increase their score.
Due to the cash collateral, people with no or poor credit can qualify for credit builder loans. Once the loan is paid off, the borrower will get their collateral back.
Auto loans
Auto loans are a popular choice for financing the purchase of cars. With the average price of a new car reaching close to $49,000, many individuals rely on auto loans to make their vehicle purchase possible. These loans allow you to secure the funds needed for your vehicle by using the car itself as collateral.
Best for people who need to purchase a vehicle
People purchasing a car will typically need to take out an auto loan. When a financial institution gives you a car loan, you receive a lump sum to pay for the car. Your monthly payment is based on the price of the car, interest rate, and the length of the loan. The loan terms are typically 36-72 months.
Pawn shop loan
Pawn shop loans are short-term loans people get at pawn shops that are secured by an item of value. Since they are backed by the item, pawn shop loans offer lower interest rates than payday loans, but they are more expensive than conventional loans. Like payday loans, pawn shop loans are also regulated by the government.
Best for people who need cash fast with no credit check
The loan terms vary depending on the pawn shop. People can use items of value (such as jewelry or electronics) to get a loan based on the item's value. There is no credit check.
Those who may not be approved for a traditional loan may want to consider a pawn shop loan. Once the loan amount is paid back, you will receive your item back. If you do not pay it off, then the pawn shop can seize the collateralized items.
What to look for when getting a personal loan
If you are considering taking out a personal loan, it's important to know what to look for in a lender. First and foremost, make sure to compare interest rates from different lenders to get the best deal.
Additionally, look into fees and other charges, such as origination fees, late payment fees, and prepayment penalties. And consider how long it will take the loan to be funded. If approved, how long until you get your money? Some financial institutions will send the money straight into your bank account as early as the same or next business day.
Another important factor is the loan repayment term -- longer terms may result in lower monthly payments, but also mean paying more in interest over time.
Finally, consider the lender's reputation and customer service track record. How is the application process? Reading reviews and doing your own research can help ensure that you choose a trustworthy lender. By keeping these factors in mind, you can make an informed decision and find a personal loan that works best for your needs and budget.
READ MORE: 6 Questions to Answer Before Getting a Personal Loan
The Ascent's best personal loans
Looking for a personal loan but don’t know where to start? Our favorites offer quick approval and rock-bottom interest rates. Check out our list to find the best loan for you.
FAQs
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It depends on your individual financial situation and credit score. If you don't have good credit or a long credit history, one option is a secured personal loan, which requires you to put up collateral to secure the loan. Payday loans are often the easiest loans to qualify for, but they're best avoided because the interest rates are exorbitant.
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Personal loans can be used for a variety of purposes, such as to consolidate debt, make home improvements, or to fund large purchases like a car. Personal loans can also be used to cover unexpected expenses, like medical bills or emergency home repairs.
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With competitive interest rates and flexible repayment terms, personal loans can provide borrowers with the financial assistance they need to achieve their goals without having to dip into their savings or rack up high-interest credit card debt.
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There are a variety of options for obtaining a personal loan, including personal loans offered by banks, credit unions, online lenders, and P2P lenders.
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David S. Chang, ChFC®, CLU® is an award-winning entrepreneur, keynote speaker, author, and consultant. He has over two decades of experience in the wealth management space and has been featured in dozens of news, radio, and podcast programs nationwide. He currently works as Head of IoT for the West Region of a Fortune 200 company. He is a graduate of the United States Military Academy at West Point and currently a Lieutenant Colonel in the California Army National Guard. He is an East-West Graduate Degree Fellow and has an MBA from the UCLA Anderson School of Management.
Robin Hartill, CFP®, is a personal finance writer and editor whose work frequently appears in various national publications. She wrote the syndicated “Dear Penny” financial advice column for four years.
Fact Checked
Ashley Maready
Ashley Maready is a former history museum professional who made the leap to digital content writing and editing in 2021. She has a BA in History and Philosophy from Hood College and an MA in Applied History from Shippensburg University. Ashley loves creating content for the public and learning new things so she can teach others, whether it's information about salt mining, canal mules, or personal finance.
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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, a Motley Fool service, does not cover all offers on the market. The Ascent has a dedicated team of editors and analysts focused on personal finance, and they follow the same set of publishing standards and editorial integrity while maintaining professional separation from the analysts and editors on other Motley Fool brands.
Please note that this calculator is not personalized financial advice and should not be considered or used as such. Nor are we promising that by use of this calculator, will you be able to save more money, preserve wealth, or otherwise.
Robin Hartill, CFP® has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Zillow Group. The Motley Fool has a disclosure policy.
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, a Motley Fool service, does not cover all offers on the market. The Ascent has a dedicated team of editors and analysts focused on personal finance, and they follow the same set of publishing standards and editorial integrity while maintaining professional separation from the analysts and editors on other Motley Fool brands.
Please note that this calculator is not personalized financial advice and should not be considered or used as such. Nor are we promising that by use of this calculator, will you be able to save more money, preserve wealth, or otherwise.
Robin Hartill, CFP® has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Zillow Group. The Motley Fool has a disclosure policy.