How Do Personal Loans Work?

What is a personal loan?

A personal loan is a lump sum you borrow from a bank, credit union or online lender and pay back in fixed monthly installments. Personal loans usually come with a set interest rate and a defined repayment term, such as three or five years.

Unlike mortgages or auto loans, where your debt is tied to an asset, personal loans are unsecured. In other words, you don’t have to put up any collateral (such as your home or car) to get one, and your approval is mostly based on your FICO score and income.

Because unsecured loans are riskier for lenders than secured loans, they usually come with higher interest rates.

Personal loan use case scenarios

You can use personal loans for almost any legal purpose, but some common things borrowers use personal loans for include:

• Consolidating high-interest debt
• Covering emergency expenses
• Paying for a wedding
• Financing home improvements
• Paying medical bills

We’ll discuss some of these scenarios in more detail below.

Debt consolidation

If you have multiple high-interest debts — maybe an auto loan and a couple of credit cards, for example — you may want to take out a personal loan to pay off those debts and then start making payments on that single loan. This can be a good idea if you qualify for a lower interest rate than what your other debts charge.

Medical expenses

Even with insurance, you may find yourself with costly medical bills at some point. Taking out a personal loan can allow you to pay off your medical expenses right away while potentially improving your credit score, because of the loan adding to your credit mix.

Home improvement

You can use a personal loan to pay for home improvement projects, though you may want to see if you’d qualify for better rates funding your projects through a home equity loan or home equity line of credit.

Major purchases

While some major purchases, such as vehicles and homes, have designated loan types, other big expenses may fall under the purview of a personal loan. You may use a personal loan to pay for wedding expenses, for example, or to fund a cross-country move.

You cannot use a personal loan to pay for education expenses or as a down payment on a home, and you should not take out a personal loan to spend on investments.

How to get a personal loan

To get a personal loan, you’ll first need to fill out an application with details about your income, credit history and how much you want to borrow. The lender will then use this info to decide whether to approve you and what rate to offer. Note that lenders may run a hard credit check that could temporarily lower your FICO score by a few points.

A few factors lenders look at when determining your eligibility include: 

• Your credit score
• Your debt-to-income ratio
• Your income 
• Your employment history 
• Your credit history

The better your finances look on paper, the better your loan terms will likely be. In general, you’ll need a credit score of at least 580 to qualify for a personal loan.

If you’re approved, the personal loan amount will be disbursed in one lump sum and deposited directly into your bank account. From there, you’ll make fixed monthly payments until the balance is paid off.

Personal loan repayment terms usually range from one to seven years, though they vary by lender. The longer the term, the more affordable your monthly payment, but the more interest you’ll pay over the life of the loan.

Application process

Depending on the lender, you may need to share your Social Security number, proof of residence, bank account information, recent tax returns and employment details when you apply.

While most lenders look at your FICO score, debt-to-income ratio and employment history to gauge how likely you are to repay the loan, each lender has different approval criteria, so check with them directly to learn what you need.

Many lenders offer online applications that take just a few minutes to complete. If you’re not ready to apply but want to have an idea of the terms you could receive, get prequalified first. Prequalification tools, typically located on the lender’s website, allow you to check your rate and compare annual percentage rates (APRs) across lenders without hurting your credit score.

Types of personal loans

Personal loans come in two main types: secured and unsecured.

• Secured personal loans are backed by collateral, such as a car or savings account. These are less common but can help you qualify if your credit isn’t great. “Plus, these types of loans often come with lower interest rates,” said Tayne. The risk is that if you default, the lender can take your asset.
• Unsecured personal loans don’t require collateral. Instead, lenders base approval on your credit score, income and overall financial profile. These loans are typically easier to apply for, but they can come with higher interest rates, especially if your credit is less than ideal.

Interest rates and fees

The interest rate you get on a personal loan can be much higher or lower than the average, depending on factors including your income, credit score, loan amount and the loan term. Generally, the more creditworthy you are, the lower your rate will be.

On top of interest, some lenders charge fees. Make sure to always read the fine print so you’re not caught off guard by these extra charges. You may pay an origination fee (which can be up to 10% of the loan amount), late fees or even a prepayment penalty if you pay off the loan early.

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Pros and cons of personal loans

Like any other financial product, personal loans have their pros and cons.

» COMPARE: Top-rated personal loan companies