Personal loans can be a useful financial tool, but many people aren’t sure exactly how they function. Whether you’re considering borrowing for a major purchase, consolidating debt, or starting a new business from scratch, understanding the mechanics of personal loans is crucial.
So how do personal loans work? Get reading to learn the ins and outs of this financing solution, along with how to obtain a personal loan and ensure you’re getting the best deal.
MoneyLion offers a service to help you find personal loan offers based on the info you provide, you can get matched with offers for up to $50,000 from our top providers. You can compare rates, terms, and fees from different lenders and choose the best offer for you.
How does a personal loan work? Key factors to understand
Personal loans deliver a lump sum of money upfront which you’ll repay via regular installments over a set time. Typically, you’ll be able to use the proceeds from your personal loan to put towards a variety of expenses.
Let’s dive into the nitty gritty key factors of how personal loans work.
Regular monthly installments
Unlike credit cards, personal loans are a financing solution that typically feature fixed repayment periods, offering borrowers a clear timeline for paying off their debt.
Monthly payments are also broken up into consistent installments. This means you’ll know exactly how much you’ll owe each month and when your loan should ideally be fully repaid, making it easier to budget and plan for the future.
Secured vs unsecured personal loans
Personal loans can be broken down into two main categories — secured and unsecured. Secured personal loans require borrowers to provide collateral, such as a car or property, to back the loan.
Collateral serves as a form of security for the lender in case the borrower defaults on the loan.
On the other hand, unsecured personal loans don’t require collateral and instead emphasize the borrower’s creditworthiness, income, and financial history.
Know that unsecured personal loans may come with higher interest rates because of the increased risk for lenders.
Flexibility in usage
In theory, personal loans may offer a greater degree of flexibility compared to other types of loans, especially because they can be used for a wider range of purposes.
Mortgages are restricted to property purchases and some home renovations. Student loans are only suitable for paying tuition and other costs associated with studying. Personal loans, however, don’t feature such limiting restrictions.
Instead, personal loans can be used to cover a range of financial needs.
This includes debt consolidation, emergency expenses, home renovations, auto purchases, weddings, moving expenses, legal fees, and more. Personal loans can also help finance major purchases like jewelry or appliances.
Keep in mind that while this is generally the case, it may not hold true for every lender and personal loan out there. Make sure to read the terms and conditions of the financing product you’re interested in to fully understand your limitations.
Funding amounts
The funding amounts for personal loans, and more specifically what you could qualify for, vary greatly depending on your income level, credit score, and current debt levels. In general, funding amounts for personal loans can range from $500 to $100,000.
Recommended: How Much of a Personal Loan Can I Get?
How interest rates and fees work on personal loans
Interest rates are essentially the cost of borrowing money. When you take out a personal loan, the lender charges you a percentage of the total loan amount as interest. The interest rate determines how much you have to repay in addition to the original loan amount.
A higher interest rate means a larger repayment amount, while a lower interest rate reduces the overall cost of borrowing.
There are two main types of interest rates — fixed and variable.
A fixed interest rate remains constant throughout the loan term, providing an extra layer of predictability in your payments. Even if interest rates rise in the market, your loan repayment amount remains the same.
A variable interest rate can fluctuate over time, usually based on a benchmark such as the prime rate or Federal funds rate. Sometimes, a variable rate may start low initially, and increase over time, potentially leading to higher monthly payments. For this reason, variable interest rates tend to carry more risk.
Alongside interest rates, lenders may also charge fees for a personal loan. These can be origination fees, late payment fees, and prepayment penalties. Make sure to read the terms and conditions associated with a personal loan offer carefully to understand the total cost of borrowing.
Personal loan repayment terms and options
In general, personal loans have a repayment term of one to seven years, but this can vary depending on the lender and your own creditworthiness and financial criteria. Shorter loan durations typically come with higher monthly payments, while longer durations allow for lower monthly payments.
When it comes to paying back your loan, here are some of your options.
Monthly or bi-weekly payments
Depending on your contract with your lender, you may be able to make payments on a monthly or bi-weekly basis. Some borrowers will opt for bi-weekly payments as it allows them to pay off the personal loan faster and potentially save on interest.
Automatic payments
Automatic payments are where the payment is automatically deducted from your bank account on the due date with no effort on your part. Setting up automatic payments can add a layer of convenience and eliminate the risk of forgetting to make a payment.
Early repayment
Early repayment entails paying off the loan, either in full or in large chunks, before the agreed-upon loan term. While this can help you save money on interest charges, it may not be a viable option in all cases.
Some lenders may charge a prepayment penalty for early repayment. You’ll need to carefully review your loan agreement to understand the consequences of early repayment.
Defaulting on a personal loan can have severe consequences. You may damage your credit score, which can hurt your ability to secure future loans or credit.
Lenders may also take legal action to recover the unpaid debt, including wage garnishments or asset seizures. If you’re facing financial difficulties, it’s crucial to communicate with your lender as soon as possible.
How to get a personal loan
Alongside understanding how do personal loans work, it’s also important to have an idea of what it means to actually apply for a personal loan. Here’s a breakdown of how to get a personal loan.
Step 1: Understand how much you’re looking to borrow
Take the time to consider what it is you’re looking to finance and how much it’s going to cost. You never want to borrow more than you can reasonably pay back, which is why it’s important to calculate your expenses and assess whether you’ll be able to repay the loan comfortably.
Try to come up with a borrowing limit as well as an idea of the interest rate and repayment term you can afford.
Step 2: Check your credit score
A good credit score will increase your chances of approval and potentially help you qualify for more favorable interest rates. If your credit score is less than stellar, you may want to consider improving it before applying for a personal loan.
Don’t know what your credit score is? Not a problem. You can obtain a copy of your credit report from one of the major credit bureaus — Equifax, Experian, or TransUnion. Or a free copy every year from Annualcreditreport.com.
Step 3: Research lenders
Personal loans are usually offered by banks, credit unions, online lenders, and other types of financial institutions. You’ll want to compare interest rates, fees, repayment options, and eligibility criteria among different lenders to find the best deal.
Step 4: Prepare an application
Once you have narrowed your options, start gathering all the required documents and begin an application. You’ll typically be asked to provide information about your income, employment status, and whether you have any outstanding debts.
You should be prepared to submit supporting documents, such as pay stubs, bank statements, and tax returns. Ask your lender what documents you’ll need to provide and make sure to review each one for any errors.
Step 5: Review and select a loan offer
Some lenders offer instant online decisions, while others may take a few days to process your application. Once you receive an offer, make sure to carefully review the terms and conditions — especially the interest rate, monthly payments, and fees.
Remember that obtaining a personal loan is a significant financial commitment. You want to make sure you borrow only what you need and can comfortably repay.
Always try to compare different loan options before making a decision, and don’t hesitate to ask questions.
Factors considered in personal loan approval
Knowing exactly what factors lenders are considering as they review your loan application may help you boost your approval odds.
1. Credit score
Your credit score reflects your repayment history on other loans, and it plays a major role in determining whether you’re a reliable borrower. The higher your credit score, generally the better your chances of getting approved for a loan.
Some ways to keep your credit score in good condition are to make sure to pay your bills on time, keep your credit card balances low, and avoid opening too many new credit accounts at once.
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2. Debt-to-income ratio
Your debt-to-income ratio is the percentage of your monthly income that goes toward paying off your debts. Lenders usually prefer borrowers with a lower debt-to-income ratio, as it shows that you have enough income to comfortably repay your loan.
To improve your chances of approval, try to pay down as much of your existing debts as possible before applying for a personal loan.
3. Income
Your income has a direct impact on your ability to repay your loan, so lenders will likely consider it heavily. Income can come from a variety of sources, employment, business profits, child support, benefits, and more. Not all forms of income are created equal, and lenders may weigh some more than others.
To improve your chances of getting a personal loan, consider ways you may be able to bring in more income. This could include negotiating higher earnings at your current job or exploring lucrative side hustles.
4. Employment history
Generally, lenders prefer borrowers who have a stable job and a consistent income. If you’re self-employed or have irregular income, you may need to provide additional documentation to prove your ability to repay the personal loan.
How to choose the right personal loan for you
As you evaluate personal loan options, compare interest rates, repayment terms, and fees to determine the best fit.
The interest rate determines how much you will pay back in addition to the principal amount. Ideally, you’ll want to choose the personal loan option that offers the lowest rate. This could help you save money in the long run.
It’s also important to choose a repayment term that aligns with both your budget and financial goals. Some lenders may also offer repayment flexibility, such as the ability to make extra payments or the option to defer payments in case of financial hardship.
Make sure to choose a loan with repayment terms that suit your needs.
It can be easy for borrowers to forget about the fees associated with a personal loan because they’re not always presented upfront in the same way as interest rates or repayment terms. But doing so can have harsh consequences.
Fees can significantly increase the cost of your loan. In some cases, they may even offset a lower interest rate.
As always, the best advice is to ensure you’re reading the terms and conditions of the loan agreement thoroughly before making a decision.
Unlocking financial flexibility and the power of personal loans
Personal loans can be a great financial tool when used responsibly. They offer the opportunity to access funds for various purposes — whether that’s consolidating debt, funding a home renovation, or covering unexpected expenses.
If you’re considering taking out a personal loan, take the time to research and educate yourself on the process. By comparing different personal loan offers and reading the terms and conditions associated with each, you’ll be in a financially stronger position.
MoneyLion makes it easy to ensure you can choose the best personal loan offer for you by compiling multiple personalized offers into a single interface. Learn what you could qualify for!
FAQ
How does a personal loan differ from other types of loans?
Personal loans provide people with flexibility. They can be used for debt consolidation, home improvements, medical expenses, weddings, or any other personal financial need. They also tend to feature fixed repayment schedules and interest rates, while credit cards tend to be variable.
How do lenders determine my eligibility for a personal loan?
Lenders will consider a variety of factors, including your credit history, income, employment history, and existing debt levels. In short, lenders want to gain a better understanding of your finances to judge your ability to repay your loan.
How much can I borrow with a personal loan?
The amount you can borrow depends on your lender and your financial situation. Most personal loans offer several thousand dollars in financing, but you may secure more or less depending on your creditworthiness, income level, and whether you’re offering collateral.
