What Is a Personal Loan?

It's money you can use for almost anything, for a price.

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A personal loan is a loan that you qualify for based on your credit history and income. Personal loans are sometimes called “signature loans” or “unsecured loans” because there is no collateral to secure a personal loan. Instead, 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 for things that improve your finances or make a significant impact on your life.

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 vary from lender to lender

Interest Rates

Rates depend on your credit and can be lower than credit card rates. With excellent credit, you may be able to borrow in the low single digits. But with thin credit or bad credit, you pay rates that are similar to credit card rates. One popular online lender has rates as high as 35.99% APR.

  • Fixed rates are most common. Your interest rate does not change, so you make the same monthly payment for the life of your loan.
  • Variable rates are available, but less popular. With a rate that floats, you may end up paying more or less interest, depending on whether rates rise or fall.

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. In many cases, you can pay off your loan early without any consequences, and that’s a great way to 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 6% of your loan amount.

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 Personal Loans

Lenders evaluate loan applications based on creditworthiness. Usually that means reviewing your borrowing history and your income.

Credit

Lenders often check your credit or obtain a credit score to find out if you’ve borrowed in the past. Your credit reports contain details about previous loans, any late payments, and public records that lenders might want to know about. Increasingly, lenders may use “alternative” credit scoring tools. For example, they might look at your history of on-time rent and utility payments as a predictor of 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. Then, they can calculate a debt-to-income ratio to make sure that the loan payment won’t consume too much of your monthly income.

Collateral

Unlike home and auto loans, personal loans do not require collateral to secure the loan. As a result, there’s no down payment or loan-to-value ratio. The drawback to using an unsecured loan is that you might pay higher interest rates. Lenders can’t foreclose on property or repossess a vehicle if you stop making payments, so they charge more to account for taking more risk.

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 marketplace lenders offer loans from investors and financial institutions. These services are 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

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

What Can You Use a Personal Loan For?

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

Consolidate 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 reinvest in your property. But if you don’t need a significant amount, a personal loan may be less expensive and easier to apply for. 

Expensive Purchases

When you need to buy something that you don’t have cash for, a personal loan could solve your need. Taking on debt is always risky, so only borrow for things that are genuine needs or that will improve your finances.

Invest 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 aren’t designed 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. For example, when you face medical expenses or you need safe transportation to keep earning income, a personal loan may make sense.

Article Sources

  1. Consumer Finance Credit Bureau: Using Alternative Data to Evaluate Creditworthiness