How do personal loans work?

When money is needed in a pinch or to help pay for that big-ticket item, a common financial move is to get a loan.

Mortgage loans, auto loans and student loans are pretty well understood — it’s fairly self-evident what they are used for. But what about another common type of loan: personal loans?

The great thing about personal loans is that they can be used for a wide range of purposes for nearly anything you need. A personal loan can be used for a home renovation project or auto repair, to help consolidate debt or to cover an unplanned cost. Ideally, personal loans are best used for a fixed amount of money, not for an ongoing expense with an open-ended total.

What is a personal loan?

A personal loan is a predetermined amount of money borrowed from a lender — usually a bank, credit union or online lender. Personal loans are typically unsecured, meaning they are not backed by collateral, making the loan approval heavily dependent on the borrower’s credit scores and credit reports.

For budget-conscious borrowers, personal loans can be more manageable than other forms of credit because they can have fixed interest rates, fixed terms and fixed payments.

• Fixed interest rates. The interest rate that is set when the loan is granted is the interest rate for the life of the loan. Rates vary from lender to lender and from borrower to borrower. Rates currently range anywhere from an APR, or annual percentage rate, of around 5% or 6% on the low end to nearly 36% on the high end.
• Fixed terms. The set period of time the borrower has to pay off the loan can vary, but in many cases it runs three to five years. The loan term is usually described in months.
• Fixed payments. With an interest rate and other loan terms that are fixed, the monthly payments are also fixed. This means payments will not fluctuate, therefore lowering the chances of any surprise increase.

Applying for a personal loan

Much like any financial decision, your choice of lender and loan amount should not be made on a whim. When applying for a personal loan, shop around — rates and terms will vary. Pay attention to these tips when comparing lenders for the personal loan that best fits your situation.

• Have all your required documents handy. When applying for a loan, the following information may be required: personal contact information; date of birth; Social Security number; employment and income information, including recent paystubs or W-2 tax forms; and loan amount needed.
• Know your borrowing needs. You know your financial responsibilities and budget better than anyone. Have a game plan before applying for a loan, and know exactly how much you need and how long you will realistically need to repay it. Personal loans can range from $2,000 to $50,000 — or even up to $100,000.
• Make sure your credit is in good shape. A borrower’s credit risk is determined by a number of factors. Lenders can consider your current credit scores, credit reports, income, debt-to-income ratio and overall financial situation.
• Take note of any fees or penalties. Normally, personal loans come with certain fees, like origination fees and prepayment penalty fees. The origination fee, charged by the lender to process the application and disburse the funds, is usually a percentage of the loan amount or a flat rate set by a specific lender. Prepayment penalties occur when the borrower wants to pay off the loan before the set terms of the loan. Since these fees are not charged by all lenders and vary in cost, be sure to ask upfront about any fees or penalties tied to the loan. 

When to get a personal loan

A personal loan is an option to explore when you need money to cover a certain expense. Borrowing money, no matter the amount, is an obligation that can work to your benefit if treated responsibly — or it can put you in serious financial trouble should you not repay the loan according to the loan’s terms. Before deciding to sign your name on that dotted line for approval, make sure this is the right financial choice for you. 

Good reasons to apply for a personal loan

• The loan is needed for a fixed amount of money.
• You can consolidate your debt from multiple payments with varying interest rates into one monthly payment, at a lower interest rate.
• You have reviewed your credit history and credit scores to get an idea of whether you meet the minimum requirements for a loan with a reasonable interest rate.
• All fees and penalties associated with the lender have been considered and are budgeted for.
• You have stable employment with a steady income to sustain the monthly payments and can repay the loan according to the selected terms.

Reasons for a personal loan that aren’t so good 

• The money is needed for a splurge purchase or the total amount needed is unknown.
• You are rushing to get a loan when you have bad credit. Bad credit can make personal loans costly and difficult to be approved for. Look into other options or even rebuilding your credit before taking next steps.
• The lender is not transparent with its fees and penalties and is willing to approve you for more than you need or can afford.
• The monthly payment for the loan will be a struggle to cover and most likely will not be paid off within the terms of the loan. 
  

Bottom line

Personal loans can be great to have in your financial toolbox, but you need to be careful. They offer many advantages for approved borrowers, yet can be an unfavorable and costly option for those who make hasty decisions.

It’s important to keep in mind that all loans need to be paid back, generally with interest. The amount borrowed, interest rate, terms of the loan, and any fees and penalties all need to be reviewed before taking out a personal loan. Even if you need the money in a hurry, explore all your loan options and choose the lender wisely.