How do personal loans work?

May 24, 2022

By Lois Sullivan

How do personal loans work?

Mom plays with child on vacation after taking out a personal loan

Personal loans are convenient, affordable options for many people. They're very versatile, and they can help you pay for unforeseen expenses, consolidate your debt, renovate your home or take care of many other tasks. Learning about how personal loans work can help you choose a loan that's right for you. Here's some additional information about how personal loans work, types of personal loans, how a personal loan could impact your credit score, and how to get one.

How do personal loans work?

A personal loan is a kind of installment loan that has a set amount and other defined terms. Borrowers get the loan amount in a lump sum, and they typically make monthly payments to pay off their debt. Unlike a credit card, a personal loan is not a a revolving line of credit.

Personal loans are available with a variety of rates and other terms. You can typically get a personal loan for anywhere from $1,000 to $50,000. The term of the loan can be one to five years long. If you don’t have prepayment penalties, you can reduce your interest expenses by making some of your payments early as well.

Types of personal loans

Several types of personal loans are available.

Unsecured

Personal loans are usually unsecured, meaning they don't require collateral, like a house, savings account, CD, or car, to qualify. With a secured loan, the borrower agrees that if they stop making payments or get behind on the loan, the lender has the option to take the collateral and sell it or use it to pay the debt. For example, the collateral for a vehicle is a car.

Secured

A secured loan may have lower interest rates. However, you risk losing your collateral if you have a financial emergency and can't make your payments on time.

Fixed-rate

Along with being unsecured, most personal loans have fixed rates. The annual percentage rate (APR) or interest rate stays the same for the life of the loan, and borrowers pay the same amount every month.

Variable-rate

You can also choose a variable-rate loan that's connected to a benchmark rate. In the United States, most banks and credit unions use the rate set by the Federal Reserve, the country's central bank. People sometimes call this the prime rate because it's the best possible APR that the most qualified borrowers may get.

Unlike a fixed-rate loan, where you know the rate you will have for the entire term of the loan, the rate in a variable-rate loan will change. Your APR and your total monthly payment can rise or fall as the prime rate rises or falls.

Cosigned or joint loans

If you can't find a loan with an affordable rate, consider speaking to a family member or friend with a high credit score. You may be able to get a better rate by applying for a cosigned or joint loan. Be aware that the person you apply with could be responsible for your debt if you fall behind or default on your payments.

Lines of credit

If you're not sure exactly how much money you'll need, think about a credit card or a home equity line of credit (HELOC). These are revolving lines of credit. You can borrow as much as you need up to a predetermined limit, and after you pay some of your debt, you can borrow more if needed. Personal lines of credit can be secured or unsecured, and HELOCs are secured by your home equity. Both options are ideal for emergency expenses like home repairs or medical bills.

How a personal loan could impact your credit score

When you apply for a personal loan or any other type of loan, the lender will consider your credit score and credit history, your income, and other details about you. The lender usually performs a hard credit check that stays on your credit report for about two years when you apply. While it's on your record, it could lower your score by a few points.

Making late payments or defaulting on your loan could also lower your credit score. If you make your payments on time, you could raise your score instead.

How to get a personal loan

Your credit score could impact your personal loan rate and monthly payments. Before applying, ensure your credit score is correct by reviewing your credit report. You can request copies of your credit reports from Experian, TransUnion, and Equifax (the credit bureaus). If there are any errors, you can dispute them.

When you apply for a personal loan, be prepared to provide financial documents like your most current tax returns and bank statements. The lender will send you the terms of the loan after they approve your application. Make sure you read the contract carefully and only agree to the terms if you can afford the payments. 

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Our quick, affordable personal loans could give you the cash you need, when you need it. Apply today!

To learn more about personal loans, check out these articles as well:


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