What Is a Personal Loan? How Do Personal Loans Work?
A personal loan is a flexible type of loan issued by a bank, credit union, or online lender that you pay back in regular, fixed payments over a set term.
Personal loans work a little differently than other types of loans. Consumer loans typically specify what the money should be spent on: Mortgages are used to purchase or refinance homes, and student loans are used to pay for an education. But there aren’t as many restrictions on how you can or can’t spend personal loan funds, which allows for more flexibility than other types of loans.
Read on to learn more about how personal loans work, including how much you can borrow, how to apply, and the different types of personal loans.
Table of Contents
What Is a Personal Loan?
As mentioned before, a personal loan is a one-time lump sum you borrow from a bank or other financial institution and repay over time, usually with interest. The funds can be used for almost anything.
Loan amounts generally range from $1,000 to $50,000, though some lenders offer personal loans up to $100,000. Repayment terms are usually anywhere from two to seven years.
💡 Quick Tip: Before choosing a personal loan, ask about the lender’s fees: origination, prepayment, late fees, etc. SoFi personal loans come with no-fee options, and no surprises.
Key Points
• A personal loan is a flexible type of loan issued by a bank, credit union, or online lender that you pay back in regular, fixed payments over a set term.
• Personal loans can be used for almost anything. Loan amounts generally range from $1,000 to $50,000, though some lenders offer personal loans up to $100,000. Repayment terms are usually anywhere from two to seven years.
• The interest rate on a personal loan is determined by the lender and is based on a number of factors, including the applicant’s financial history, income, debt, and credit score.
• Personal loans can be used for various purposes, including debt consolidation, home improvement expenses, wedding costs, unexpected medical expenses, moving expenses, funeral expenses, family planning, car repairs, and vacation
• Before you apply for a personal loan, you’ll want to consider how much money you want to borrow, how much you can afford to pay each month, how long you want to make payments, and whether or not you want to put up collateral.
How Do Personal Loans Work?
Personal loans are typically unsecured loans (meaning you don’t have to pledge an asset to secure the loan) that provide you with money you then pay back in regular installments over the term of the loan.
How Do You Get the Money?
The first step is applying for a personal loan (more on that below). After loan approval, the lender typically deposits the loan proceeds directly into the borrower’s bank account.
Repaying a Personal Loan
You repay a personal loan in monthly installments that go toward both principal and interest.
Typically, personal loans are amortized. This means the total amount you owe is divided into equal monthly payments over the term of the loan. Even though the total monthly payment remains the same, the amounts being directed to principal and interest will change each month. An amortization schedule can show you exactly how much of your payment is going towards paying down the principal and how much is being paid in interest.
Personal loans with longer terms may offer lower monthly payments, but cost more in interest over the life of the loan. A shorter-term personal loan can have higher monthly payments, but cost less overall in interest.
How Personal Loan Interest Rates Work
The interest rate on a personal loan is determined by the lender and is based on a number of factors, including the applicant’s financial history, income, debt, and credit score. Generally speaking, the better an applicant’s credit score, the better the chance they have to receive a lower interest rate on the loan. The higher the interest rate, the more money the loan will cost over its term.
Personal Loan Uses
Personal loans can be used for just about anything. That said, there are some common reasons people take out different types of personal loans, including:
• Debt management and consolidation
• Unexpected medical expenses
• Moving expenses
• Funeral expenses
• Car repairs
• Vacation
The Personal Loan Application Process
While it’s not as simple as walking into a bank, asking for a loan, and walking out with a check, the application process for personal loans is relatively easy.
Before you apply for a personal loan, you’ll want to consider how much money you want to borrow, how much you can afford to pay each month, how long you want to make payments, and whether or not you want to put up collateral (though less common, some lenders offer secured personal loans). There may be other considerations for specific financial circumstances, which can vary from person to person.
Checking Your Own Credit
Because lenders will be looking closely at your creditworthiness, it’s a good idea to give your financial health a check-up before you begin the application process. You can get a free copy of your credit reports from the three main consumer credit bureaus — Equifax, Experian, and TransUnion — for free at AnnualCreditReport.com.
Once you get your reports, it’s a good idea to review them carefully and report for any errors. Correcting anything that isn’t accurate means your credit report will look as good as possible to lenders.
Comparing Loans
Just like shopping around for the best prices before making a large purchase, comparing lenders’ rates and terms is a smart move before the application process actually begins.
Here are some things to look for when researching lenders:
• How much do they lend on personal loans? If the amount you need to borrow doesn’t fall within the range offered by the lender, you may need to look elsewhere.
• Do they charge any fees or penalties? Some lenders charge an origination fee equal to a percentage of the loan amount to process your application. Some personal loans also have a prepayment penalty if you pay off your loan ahead of schedule.
• How are fees and penalties charged? Some lenders may roll any fees into the loan amount, which increases the total amount you’ll owe. Other lenders may deduct the fee amounts from the loan proceeds, so the amount you receive will be lower than the actual amount of the loan.
• Can I get prequalified so I’ll know what interest rate they might offer me? Prequalification involves the lender doing a soft pull on your credit report, which will not affect your credit score. This step will give the lender a sneak peek at your financial history so they can give you an estimated interest rate. Going through this process with multiple lenders is one way to compare rates and terms you may qualify for.
• What if I can’t make my loan payments due to financial hardship? Missed or late payments could result in late fees, affect your credit score, or lead to your account being sent to collections. Some lenders may offer protections for borrowers who have lost their job or are having difficulty making their payments for other reasons.
Applying for a Loan
When you’ve selected a lender, it’s time to submit the actual application. For an unsecured personal loan, lenders typically require:
• A photo ID
• Proof of address
• Proof of income or employment
Each lender has different requirements, though, so it’s important to carefully read and follow the lender’s application instructions. At this stage, the lender will usually do a hard credit check, which can have a small and temporary negative affect on your credit score.
Waiting for Approval
Once you’ve submitted the application and all required documents, it’s time to play the waiting game. Rest easy, though, because some personal loan approvals happen quickly — sometimes in just a day. More complicated applications could take a week or more.
Personal loans can range anywhere from $1,000 to $100,000, depending on the lender. Once you apply and are approved for the loan, you’ll receive the amount of money you were approved for in a lump sum, minus any origination fees that some lenders may charge. You then start paying back that money in installments which are set by the specific terms of your loan.
Types of Personal Loans
There are a variety of different types of personal loans. Factors like how much money you plan to borrow, your credit and financial history, and how much debt you already have will influence which type of personal loan is right for you. Here’s a look at some common personal loan options.
Unsecured vs Secured Personal Loans
An unsecured personal loan is the most common type of personal loan. Unsecured means the loan is not backed by collateral, like a house or car. The approval and interest rate you receive on an unsecured personal loan is mostly based on your creditworthiness.
Secured personal loans require an asset to be pledged to “secure” the loan. Think of a house when it comes to a mortgage loan, or a car when it comes to a car loan. If you fail to repay your loan, the lender can then seize the collateral.
Some banks offer secured personal loans that allow you to borrow against the equity of your car, personal savings, or other assets. Since secured loans are backed by an asset that the lender can seize if you default on the loan, they generally have a lower interest rate than an unsecured personal loan.
Here’s a look at some pros and cons of unsecured and secured personal loans:
| Unsecured Personal Loans | Secured Personal Loans | |
|---|---|---|
| Advantages | Funds may be disbursed the same day or within a week
Interest rates are typically lower compared to credit cards No collateral required |
Interest rates are typically lower compared to unsecured personal loans
Can be a good way to improve credit if payments are regular and on time Tend to have a longer repayment period |
| Disadvantages | May need to meet minimum credit score requirements for approval
Interest rates may be higher compared to secured personal loans Credit score may be negatively affected if borrower defaults |
Collateral is required
Lender can seize the collateral if borrower defaults Application and approval process may involves more steps |
Fixed-Rate vs Variable-Rate Personal Loans
Most personal loans are typically fixed-rate loans, meaning your rate and monthly payment stay the same (or are fixed) for the life of the loan. Fixed-rate loans can make sense if you’re looking for something with consistent payments each month. A fixed-rate loan is also worth considering if you are concerned about rising interest rates on longer-term personal loans.
As the name suggests, the interest rate on a variable-rate loan can fluctuate over the life of the loan. Interest rates on this type of loan are tied to benchmark rates or indexes. Based on how the benchmark rate or index changes, the interest rate on a variable-rate loan will also change, directly affecting your monthly payment.
Generally, variable-rate loans carry lower annual percentage rates (APRs) and some have limits on how much the interest rate can rise or lower over a specific period, or even over the life of the loan. A variable-rate loan could be a good choice if you are taking out a small amount of money with a short repayment term.
Here are some pros and cons of variable-rate personal loans and fixed-rate personal loans. Choosing between variable vs. fixed rates will come down to personal preference and what you are approved for.
| Variable-Rate Personal Loans | Fixed-Rate Personal Loans | |
|---|---|---|
| Advantages | Loans often start out with a lower interest rate compared to fixed-rate loans
If benchmark rate goes down, interest rate on the loan also goes down Flexible |
Monthly payments are consistent
Can avoid rising interest rates Easy to understand |
| Disadvantages | If benchmark rises, the cost of the loan also rises
Borrowers have a greater risk of defaulting on loan if the interest rate increases significantly As interest rates change, so will the monthly payment |
Won’t be able to take advantage of changes in interest rates
Interest rates tend to be higher compared to variable-rate loans May pay more over time if you took out your loan when interest rates were high |
Small vs Large Personal Loans
Just as personal loans are taken out for a variety of reasons, the dollar amount borrowed can vary, too.
A small personal loan, which is generally for $3,000 or less, typically has a lower APR than other types of short-term debt, such as payday loans. Many banks and other financial institutions have limits on the minimum amount they’ll lend. Some credit unions may offer alternatives to payday loans in an effort to help their members save money and avoid being stuck in a cycle of debt.
A large personal loan might be used to pay for major expenses such as home repair or remodeling, medical expenses, or an expensive life event, such as a wedding. Some lenders offer personal loans up to $100,000.
It’s important to keep in mind your ability to repay the loan when deciding how much to borrow. Here’s how small and large loans compare:
| Small Personal Loan | Large Personal Loans | |
|---|---|---|
| Advantages | Can use the money for a wide variety of purposes
Interest rates are typically lower compared to credit cards Usually has better terms than payday loans |
Can use the money for a wide variety of purposes
Greater ability to combine multiple credit card balances into one balance Can be a good way to improve credit if payments are regular and on time |
| Disadvantages | Can often get a better interest rate with a larger loan
No grace period Lenders may limit how much you can borrow |
The larger the loan, the more debt you’re taking on
Increases your debt-to-income ratio Lenders may limit how much you can borrow |
What Personal Loan Lenders Look at in Your Application
When you apply for a loan, the lender typically considers your credit score, debt-to-income (DTI) ratio, and other factors.
Credit Score
A person’s credit score shows lenders what the theoretical likelihood of that person paying back a loan would be. Generally, the lower a person’s credit score, the more of a risk they are assumed to be. Conversely, the higher a person’s credit score, the lower a risk they are assumed to be — and the more likely they are to be approved for lower interest rates and higher loan amounts.
Debt-to-Income Ratio
Your DTI is a percentage that tells lenders how much money you spend on monthly debt payments versus how much money you have coming into your household. You can calculate your DTI by adding up your monthly minimum debt payments and dividing it by your monthly pretax income.
Lenders generally want to see a DTI of 35% to 40% or less but may make exceptions if you have good credit.
Credit History
Lenders will review your credit report for anything that might stand out as a risk for them. If there are a high number of inquiries on your credit report or if there were multiple debt accounts opened in a short time period, that might indicate high risk to a lender. Borrowers who are considered high risk may find it more difficult to get a loan and could pay higher interest rates.
Deciding If a Personal Loan Is Right for You
Not sure whether a personal loan makes sense for your situation? Here are some questions to ask yourself:
• Do I need the money quickly? If you do, then a personal loan might be a smart move.
• Can I afford the monthly payments? Before you take on any debt, it’s important to set a realistic plan on how you’ll repay what you owe.
• Do I already have a high amount of debt? Taking out a personal loan when you have significant debt can put a serious dent in your budget and savings goals. It can also increase your DTI, which lenders look at when reviewing your loan application.
• Do I have a “bad” credit score? If your credit score isn’t so great — FICO defines “bad” as 579 or below — then you may want to wait on taking out a loan and instead work on your credit.
• Does a personal loan offer the lowest interest rate of all the options available? It’s a good idea to shop around for the rate and terms that best fit your needs before you apply with a lender.
Recommended: Personal Loan Calculator
Alternatives to Personal Loans
There may be times when you need help covering a big expense, but taking out a personal loan isn’t the best choice. Fortunately, there are alternative funding options. Here are a few you may want to explore:
Credit Cards
Like personal loans, credit cards offer a line of credit that can be used for a wide range of purposes. You may want to consider using a credit card if you have a smaller expense that you can pay off quickly.
Home Equity Line of Credit
If you own your home and have at least 20% equity, you may be able to get a home equity line of credit (HELOC). This option could be a smart move if you need to borrow a large amount of money or plan on having ongoing expenses, like those with a remodeling project.
401(k) Loan
If you have a financial emergency or want to pay off high-interest debt — and no other option is available — then you may want to consider borrowing from your 401(k). Keep in mind that you may face taxes and penalties when you withdraw the money, so be sure you understand how your plan works and what it allows.
💡 Quick Tip: While HELOCs may require an appraisal before you get approved, a SoFi home improvement loan does not. That means you can get approved and funded the same day.*
The Takeaway
Personal loans can offer flexibility when you’re looking for funds for a variety of uses, and typically have lower interest rates than credit cards. Depending on your financial needs and financial circumstances, there may be a personal loan that fits. Comparing multiple lenders is a good way to make sure you’re getting a personal loan that works for you.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
FAQ
How do personal loan payments work?
Personal loans are typically repaid in monthly installments. When you take out a personal loan, you agree to repay the borrowed amount plus interest over a set period, usually through equal monthly payments. Each payment consists of a portion that goes towards reducing the principal balance and another portion that covers the interest charges. The loan agreement will specify the amount of each payment, the duration of the loan, and the interest rate.
What are the risks of a personal loan?
Personal loans come with certain risks that borrowers should be aware of. One risk is defaulting on the loan, which can lead to late fees, damage to your credit score, and even legal action from the lender. Another risk is needing to take on additional debt if you borrow more than you can afford to repay. In addition, personal loans may have higher interest rates compared to secured loans like mortgages or auto loans. It’s important to carefully consider your financial situation and ability to repay before taking on a personal loan.
What are the disadvantages of a personal loan?
Personal loans have a few potential disadvantages to consider. One is that they tend to have higher interest rates compared to loans secured by collateral. Personal loans may also have origination fees or other associated costs. Another potential disadvantage is that, should you miss payments or default on the loan, it could have a negative impact on your credit score.
Is a personal loan bad for your credit score?
A personal loan itself is not inherently bad for your credit score. In fact, when managed responsibly, a personal loan can have a positive impact on your credit. Making timely payments and paying off the loan as agreed can demonstrate your ability to handle debt responsibly, which can improve your credit profile. However, if you miss payments or default on the loan, it can have a negative affect on your credit. It’s important to borrow within your means, make payments on time, and consider the impact on your credit score before taking on a personal loan.
Does personal loan money go to your bank account?
Yes, when you are approved for a personal loan, the funds are typically deposited directly into your bank account. This allows you to have immediate access to the loan amount. The specific timeline for receiving the money may vary depending on the lender and the loan application process.
Do you get money right away from a personal loan?
The timing of receiving money from a personal loan can vary depending on the lender and their processes. Typically, you receive the money within five to seven business days of approval, and some lenders even offer same-day funding.
* Same-Day Personal Loan Funding: 82% of typical SoFi Personal Loan applications, excluding Direct Pay Personal Loans and Personal Loan refinance, from January 1, 2022 to January 1, 2023 that were signed before 7pm ET on a business day were funded the same day.
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