What is a personal loan? Terms to know.

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In a Nutshell

A personal loan is a type of installment loan, which is a loan you pay back over a set period of time with interest. Some personal loans don’t require collateral and are available for purposes ranging from debt consolidation and home improvements to emergency expenses and major purchases.

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Whether you want to consolidate debt or finance a wedding, a personal loan can help you borrow the money to achieve your goals.

Personal loans have some key differences from revolving credit, like credit cards or lines of credit. With a personal loan, you get a set amount of money and repay it in monthly payments, called installments, for a predetermined time period. Repayment terms vary. Depending on your loan, your loan term could range from one year to seven years, though that will vary by lender.

After you’ve paid the debt in full, the loan ends and your account is closed. To borrow more money, you’d have to apply for another loan.

If you’re considering getting a personal loan, you’ll want to understand the jargon you’ll encounter during the process. Terms like “collateral,” “credit score,” “prepayment penalty” and “prime rate” could throw you for a loop if you don’t know what they mean.

We’ll guide you through basic personal loan definitions and some terms you should understand before taking out a loan.



How do personal loans work?

Personal loans can be secured or unsecured. For a secured loan, you must put up some personal property as collateral, like a savings account or certificate of deposit. If you default on the loan, the lender typically has the right to seize your collateral as payment for the loan.

Unsecured personal loans aren’t backed by collateral. Instead, lenders look at factors like your financial history and credit to decide whether you qualify for the loan. Because they’re not secured, unsecured personal loans often come with a higher interest rate than you might get for a secured loan.

Personal loans are available from banks, credit unions, online lenders and peer-to-peer lending platforms.

What to know before you apply

Before you apply for a personal loan, you should think about why you want it and evaluate other options. If you’re thinking about using a loan for something you want but don’t need, it’s probably better to save up for it instead of borrowing and paying interest. If that’s not an option though, make sure you can afford adding the monthly payments into your budget.

If you want to use a personal loan to pay off debt, consider other options as well, like a card with an introductory 0% rate on balance transfers. Paying the balance in full before the introductory rate ends means you won’t have to pay any interest on the transferred balance.

But failing to pay your balance in full by the end of the intro period could cause you to owe a lot in interest on any remaining balance. You’d have to keep your eye on the introductory time frame to make it worth your while.

When you apply for a personal loan, the lender will typically pull your credit. This can involve what’s known as a hard inquiry, which could stay on your credit reports for about two years, and could negatively affect your credit scores, depending on your situation.

Personal loan lingo: The definitions

When you’re comparing loan options, there are some common terms you’ll want to understand. Browse this list to help guide your research.

Annual percentage rate

APR is the amount of interest and other costs (such as fees) that you pay to borrow money, expressed as an annual rate. The APR represents the total annual cost of borrowing money.

Automatic payment

An automatic payment is an amount that’s deducted automatically from your bank account and paid to your lender as your loan payment. Some lenders offer a rate discount if you agree to set up automatic payments.

Collateral

Collateral is property that you own and offer your lender to secure your loan. If you don’t repay the loan, the lender can typically claim the collateral to pay the loan.

Credit report

Credit reports show information about your use of credit and credit history. The three major consumer credit bureaus — Equifax, Experian and TransUnion — each prepare a credit report that may be used by lenders. They generally include personal information like your payment history, how many credit accounts you have, how much credit you’re using and how long you’ve been using credit. Most reports include your name, Social Security number, current and former addresses, and employer history.

Credit score

Your credit scores are numerical representations of the information in your credit reports. Depending on the credit-scoring model used, scores typically range from 300 to 850. Lenders often view credit scores as an indication of how likely you are to repay debt. Higher scores may indicate to lenders that you are more likely to make payments on time and repay the loan as agreed.

Default

If you fail to repay a loan according to the terms of your loan agreement, the loan will usually be considered to be in default.

Delinquent

When you make late payments or miss payments, your credit account will be considered delinquent.

Direct deposit

Direct deposit is a service where money is electronically deposited into a bank account (without a paper check). If you’re approved for a personal loan, your lender may offer to directly deposit the funds into your bank account.

Fixed interest rate

A fixed interest rate doesn’t change or adjust with an index during part of the term or the entire term of the loan.

Installment loan

An installment loan is a loan for a fixed amount of money that requires payments at specific intervals for a set period of time. Personal loans are a type of installment loan as well as auto loans, student loans and home loans.

Interest/interest rate

Interest is what you pay to borrow a sum of money, not including fees or additional charges. The interest rate is expressed as a percentage of the amount of money you borrowed. Interest rates are usually annualized.

Lender

A lender is a company, organization or individual that makes a loan to a borrower. Lenders can include banks, credit unions, finance companies, online lenders and peer-to-peer lenders.

Monthly payment

Your monthly payment is the amount that you’re required to pay to the lender by a specific date each month until your loan has been repaid in full.

Online loan application

An online loan application is a form that you’re required to complete via the internet to apply for a loan from a lender. Some lenders allow you to check if you prequalify online, which can give you an idea of whether you may get the loan if you submit a loan application online. Prequalification isn’t a guarantee of approval, and if you’re approved, you may be offered different terms than what you saw on your prequalification offer.

Origination fee

An origination fee is a fee that some lenders charge for initiating your loan application and issuing your loan. An origination fee is usually calculated as a percentage of your loan amount.

Peer-to-peer lending

If you opt for peer-to-peer lending, you’re getting a loan from individuals or investors who lend to you without the use of a traditional financial institution, such as a bank or credit union. Borrowers and lenders are typically matched through a peer-to-peer, or P2P, online lending service, sometimes called a “platform.”

Prepayment penalty

A prepayment penalty is a fee that some lenders charge if you pay off all or part of your loan early. The penalty compensates the lender for interest you didn’t pay because you made fewer payments than the lender expected to receive.

Prime rate

The prime rate is the lowest interest rate that commercial banks will charge borrowers with the best credit. To qualify for this rate, you typically need to have excellent credit. The Wall Street Journal publishes a prime rate that’s a consensus of large commercial banks’ rates.

Principal

Principal is the amount of money you borrowed from your lender, excluding interest. As you pay off your loan, this amount will decrease.

Repayment term

Your repayment term is the maximum amount of time you have to repay the loan in full.

Secured loan

A secured loan is backed by collateral that your lender can typically collect if you fail to repay the loan as agreed.

Unsecured loan

An unsecured loan is not backed by collateral.

Variable interest rate

A variable interest rate is a rate that can change during the loan term. Your loan agreement should specify how this rate is determined and under what circumstances it can change. A variable interest rate usually changes with the prime rate, as published in the Wall Street Journal.


Bottom line

A personal loan can be a helpful financial tool when you need money for a big expense or to consolidate debt. But it’s important to understand exactly what you’re agreeing to when you take out a personal loan. And you need to have a solid plan for repaying the loan according to your agreement with the lender.

Learning common personal loan terms, and researching how personal loans work, can help you feel more confident that you’re making a good decision and getting a personal loan with the best terms for you.