How do personal loans work?

A personal loan can be a valuable tool for those who need cash quickly. These loans are money borrowed from a financial institution or online lender that's paid back over time, often with fixed monthly payments.

Personal loans can go toward most uses — filling in gaps in your budget or helping to consolidate debt, for instance. If you're struggling to bring your finances together, a personal loan can help you get caught up.

What are personal loans?

A personal loan is a lump sum of money you borrow from a bank, credit union or other lender for just about any purpose, then pay back in installments. You can use a personal loan to pay off other debts, make an expensive purchase, make home improvements, cover medical bills, go on vacation — the list is endless. Some lenders offer specific types of personal loans that are purpose-specific, like debt consolidation loans.

How personal loans work

Most personal loans are unsecured loans, meaning a borrower can get funds without offering collateral, which is an asset that backs up the loan.

Lenders typically require proof of identity, proof of income and other documentation when you apply. They also check your credit history and score and look at factors such as your debt-to-income (DTI) ratio before making an approval decision.

Most personal loans are unsecured and may have higher rates than secured loans.

Most personal loans have flexible terms. If you want to keep your overall interest costs low, you can find a short-term loan of just two to three years.

If you want to prioritize a lower monthly payment, however, you can choose a longer term that provides more time for repayment.

Lenders have minimum and maximum loan amounts, but the amount you’re approved for depends on your financial profile. You’ll be asked how much you want to borrow while applying, but there’s no guarantee the lender will extend that amount.

Because most personal loans are unsecured, they carry more risk for lenders. For this reason, lenders require a good credit score to secure a lower interest rate.

Unsecured personal loans have higher interest rates than secured loans, like secured personal loans, auto loans and home loans, but the rates are often lower than those on credit cards.

Types of personal loans

Though most personal loans are unsecured, there are some personal loans that require collateral. If you’re able to offer a valuable asset as security in exchange for a better interest rate, a secured personal loan could be right for you.

Secured personal loans

The most common types of secured loans are mortgages and auto loans. With these loans, if you fail to make payments on time, the lender can take possession of the asset you’ve provided as collateral and sell it to get its money back. Secured loan interest rates tend to be lower than unsecured loan rates, and you can often borrow more money for a longer time.

Though secured loans are often more affordable, there is a greater risk to the borrower. It's important to recognize that you could lose a valuable possession if you fail to pay back the loan.

Unsecured personal loans 

Most personal loans are unsecured and have no assets serving as collateral for the loan. These loans, also called signature loans, are riskier for lenders — if you miss payments, the lender can’t use your property to recover its losses. This is why unsecured loans tend to have higher interest rates.

Your credit score, income, DTI ratio and other factors determine how much you can borrow and what rate you pay. To get an unsecured personal loan with lower rates and fees, you usually need a credit score of around 670 or better.

What can you use a personal loan for?

One key reason to pursue a personal loan is the flexibility in terms of use. You can use a personal loan for almost any legal purpose. Borrowers use personal loans for:

• Consolidating high-interest debt
• Making a home improvement
• Paying medical bills
• Getting a motorcycle or car
• Repairing a vehicle
• Buying a boat or RV
• Paying for a wedding or a trip

Keep in mind that some lenders may offer personal loans for specific purposes, such as debt consolidation. When you apply, it’s common for the lender to ask how you plan to use the funds.

If you find a lender you like, you might be able to use it for loans in the future. As an example, one of our reviewers from North Carolina liked Best Egg so much that they took out a second loan with the company to consolidate their debt.

What you need to get a personal loan

To get a personal loan, you need to meet a lender’s eligibility requirements. These qualifications differ by lender. The main factors that lenders consider are the following:

• Credit history and score: To get access to multiple unsecured personal loan offers and lower rates, you generally need a credit score of at least 670. This doesn’t mean you can’t qualify for a personal loan with a lower score, though.
• Employment/income: Lenders want to see that you have a regular and stable source of income so you can pay back the loan. Your income helps determine how much you can borrow. Be prepared to show the lender pay stubs, tax returns, W-2s, bank statements and employer information.
• Debt-to-income ratio: Your DTI ratio shows how much of your gross monthly income goes toward paying debts, like housing or a car payment. You’ll be asked to list all these debts. Lenders set their own DTI qualifications — a ratio of 35% to 40% or below is a standard requirement.

When applying for a personal loan, you should also have proof of identity (e.g., Social Security number, driver’s license), proof of address (e.g., utility bills, lease agreement) and your contact information. The lender will ask how much you want to borrow, and you may need to state how you plan to use the funds and your loan term preference.

Bottom line

A personal loan can help cover almost any expenses you have and, when paid off on time under the terms of the agreement, can also help improve your credit. These loans are flexible when it comes to amounts and terms, and they can be a valuable tool for someone who needs extra funds quickly.

If you qualify for a personal loan and you can afford it, it may make sense to consider this borrowing route. Just make sure you compare offers from multiple lenders before choosing the one that’s right for you.