What Is a Personal Loan?

You don't need collateral for this type of borrowing

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 only 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 can vary from lender to lender and there are a few factors to take into account. 

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 single digits.

  • 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.

If you have thin credit or bad credit, you may pay rates that are similar to credit card rates, which were an average of 20.15% in April 2020. You also might need a 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 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 of 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 also are 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.

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'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.

Taking on debt can be risky. If you can postpone the purchase until you have cash, you won't have to worry about whether you can repay the debt.

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 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 you need safe transportation to keep earning income, a personal loan may be an option that makes sense.

Article Sources

  1. USA.gov. "Credit Issues." Accessed May 22, 2020.

  2. Board of Governors of the Federal Reserve System. "Consumer Credit - G.19." Accessed May 22, 2020.

  3. Experian. "Understanding Loan Origination Fees." Accessed May 22, 2020.

  4. Experian. "Personal Loans: What to Know Before You Apply." Accessed May 22, 2020.

  5. Consumer Finance Credit Bureau. "Using Alternative Data to Evaluate Creditworthiness." Accessed May 22, 2020.

  6. Mycreditunion.gov. "Personal Loans: Secured vs. Unsecured." Accessed May 22, 2020.

  7. Experian. "What Is a Personal Loan?" Accessed May 22, 2020.

  8. Experian. "Is a Personal Loan Better Than a Student Loan." Accessed May 22, 2020.