What Is a Personal Loan?

Definition & Examples of a Personal Loan

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A personal loan is a lump sum of money borrowed from a financial institution that can be used for almost any purpose.

Learn more about personal loans and how they work.

What Is a Personal Loan?

A personal loan is a loan you qualify for based on your credit history and income. Personal loans are sometimes called signature loans or unsecured loans because there is typically no collateral required to secure a personal loan.

Collateral is an asset that can be seized and sold to repay the loan. Home loans are secured by the home being financed. In most cases, lenders approve personal loans by evaluating your creditworthiness.

Personal loans are relatively easy to apply for and qualify for when compared to home and auto loans. That makes them useful for everything from small home improvements to expensive purchases. You can use the money for almost anything, but it’s wise to borrow only as much as you need—and only for things that improve your finances or make a significant impact on your life.

  • Alternate names: Signature loans, unsecured loans

How Personal Loans Work

When you get a personal loan, you typically receive your money in a lump sum, and you repay with fixed monthly payments over time. However, the details can vary from lender to lender and there are a few factors to take into account. 

Interest Rates

Your interest rate depends on your credit and can be lower than credit card rates. With excellent credit, you may be able to borrow in the single digits.

Personal loans typically have fixed interest rates. Your interest rate doesn't change, so you make the same monthly payment for the life of your loan.

They can also have variable rates, but this option is less popular. With a rate that can change, you may end up paying more or less interest depending on whether interest rates are rising or falling.

If you have a limited credit history or bad credit, you may pay rates that are similar to credit card rates. You also might need a creditworthy co-signer for the loan.

Repayment Time

You usually repay personal loans over one to five years, but other terms are available. Compared to credit cards, personal loans can reduce the amount you spend on interest and provide a definite payoff date. With many personal loans, there is no prepayment penalty, so you can pay off your loan early and save on interest.

Origination Fees

Some lenders charge origination fees for personal loans, while others build all of the costs into the interest rate. When you pay origination fees, your lender takes an upfront charge based on the amount you borrow. Origination fees usually range from 1% to 8% of your loan amount and may depend on your credit score.

In most cases, you pay fees out of loan proceeds, so you receive less than the full loan amount. Be sure to borrow slightly more than you need to cover the fee.

How to Get Approved for a Personal Loan

Lenders evaluate loan applications based on creditworthiness. Here are the factors they usually consider.

Credit History

Lenders often check your credit or obtain a credit score to find out how you've handled credit in the past. Your credit reports contain details about previous loans, any late payments, and public records that lenders might want to know about.

Lenders may also use alternative credit scoring tools. For example, they might look at your history of on-time rent and utility payments to predict how you’ll repay a loan.

Income

Lenders need to verify that you have enough income to repay your loan. They may ask for details about your employment and income. They may also look at your current debt to make sure that adding a loan payment won’t consume too much of your monthly income.

Types of Personal Loans

If you decide to try a personal loan, you can borrow from several sources.

Standard Personal Loans

Banks and credit unions have a long history of offering personal loans. You can often apply in person or online and receive funds in your checking account quickly.

Online Lenders

Peer-to-peer (P2P) sites and other online lenders offer loans from investors and financial institutions. These services are the most likely to use alternative credit scoring models, and the application process is often easy.

Specialized Lenders

Some lenders work directly with service providers. They might fund dental work, fertility treatment, or landscaping projects. Borrowing is convenient, but it’s wise to shop around and compare offers.

Credit cards are also technically personal loans. However, they’re revolving loans that work differently from what most lenders call a personal loan.

Spending a Personal Loan

You can spend the money from a personal loan on almost anything you want.

Consolidating Debt

If you owe money on credit cards with high interest rates, you can pay off those debts with a personal loan that has a lower rate. You can eliminate debt more quickly because less of each monthly payment goes toward interest costs.

Small Home Improvements

It’s common to use home equity loans for home improvement projects because you're reinvesting in your property. But if you don’t need a significant amount, a personal loan for home improvements may be less expensive and easier to apply for. 

Expensive Purchases

When you need to buy something big or expensive that you don’t have the cash for, a personal loan could solve your need.

Investing in Yourself

Personal loans may be able to provide funding when you start a business or need to learn new skills for your career. However, some lenders limit how you can use loan proceeds. For example, some personal loans don't permit you to use them to pay for higher education expenses.

Emergencies

Ideally, you have emergency savings available for life’s surprises. But sometimes there are no options besides borrowing. If you're facing steep medical expenses or another emergency, a personal loan might make sense.

Key Takeaways

  • A personal loan is a lump sum of money borrowed from a financial institution that can be used for almost any purpose.
  • You typically qualify based on your credit history and income. These loans also don't require collateral in most cases. 
  • Personal loans usually have fixed interest rates, relatively short repayment terms, and origination fees. 
  • You can obtain personal loans through banks, credit unions, online lenders, and specialized lenders. 
  • You can spend a personal loan as you see fit in most cases, but some lenders don't allow personal loans to be used for higher education expenses. 

Article Sources

  1. Board of Governors of the Federal Reserve System. "Consumer Credit - G.19." Accessed Aug. 30, 2020.

  2. Experian. "Understanding Loan Origination Fees." Accessed Aug. 30, 2020.

  3. Consumer Finance Credit Bureau. "Using Alternative Data to Evaluate Creditworthiness." Accessed Aug. 30, 2020.

  4. Experian. "Is a Personal Loan Better Than a Student Loan?" Accessed Aug. 30, 2020.