A personal loan is a large sum of money borrowed from a bank, credit union or online lender with a fixed interest rate and repayment term. Determine whether a personal loan is right for you by understanding how they work, including the pros and cons.
What Is a Personal Loan?
Personal loans are flexible in use and are repaid over a specific term at a fixed interest rate, which is determined by the lender you choose. While some loans, such as mortgage loans, are used for a specific purpose, personal loans can be used for many things — debt consolidation, vacation, medical bills and more.
Personal loans can help you reach specific financial goals at a low-to-moderate interest rate. Before you apply, you should understand the types, uses and how it may affect your credit score. All these factors may help you decide whether a personal loan is beneficial to your personal finances.
- The principle is the amount you promise to pay back to the lender, not including the interest. For example, if you’re taking out a loan of $10,000, that amount is the principle.
- Interest is a percent of the principle that is charged by the lender for the use of their funds. The average personal loan interest rate was 9.34% in 2019, according to the Federal Reserve.
- APR stands for annual percentage rate. For personal loans, APR combines the interest rate with any fees or charges, such as an origination fee. If there are no extra fees or charges on a personal loan, the APR will only account for the interest, making the APR and interest percentage the same.
- A term is the amount of time you must repay the loan. A typical personal loan term is two to seven years.
- Monthly Payment
- The monthly payment for a personal loan is the amount you are charged monthly to repay the loan. There are government affiliated personal loan calculators available to help you estimate your monthly payment cost.
Personal Loan Types
All personal loans follow a payment plan to pay back a sum with interest to the lender. There are four different types of personal loans, which differ slightly. It’s important to understand each type’s functionality before applying.
- Almost all personal loans are unsecured, meaning the lender does not require collateral to give you a loan.
- In the rare case your personal loan is secured, this means you must offer something as collateral to get the loan. For example, collateral may include your house or car. If you can’t pay back the loan, the lender can take possession of your collateral.
- Credit-builder loan
- Unlike secured and unsecured loans where you receive a lump sum from the lender and pay it back over time, a credit builder loan requires you to make the monthly payments first. After you pay off the loan, then you receive the full loan amount at the end of the term. This type of personal loan is typically used to help build your credit score.
It’s important to understand each loan type before applying.
For example, if you need a loan to fund a time-sensitive event, like a wedding, a credit-builder loan would not be the right option since you get the full loan amount at the end of the term.
If you don’t have assets to lend as collateral, then you may consider choosing an unsecured loan instead of a secured loan.
Personal Loan Uses
Most who are considering a personal loan want to consolidate their debt, finance a home improvement project or cover important life event costs like a wedding or cross-country trip. Keep in mind that personal loans should only be used to reach certain financial goals, not to add more debt that you cannot afford.
Although most people use personal loans for a one-off purchase, some use a personal loan to increase the value of an asset. For example, remodeling a bathroom in your home will increase the selling value. In the long run, you could end up making a profit.
How to Apply for Personal Loans
When applying for a personal loan, there are different requirements depending on your lender.
While a bank is the most popular option, it has the strictest requirements — including a decent credit score. If you have a low credit score, you have a better chance of getting a personal loan from a credit union or online lender.
There are five steps that can help you apply for a personal loan.
- Determine the amount you need
- Once you decide how much you need, confirm that you can afford the monthly payments. You can use an online personal loan calculator for a more accurate estimation. Remember that each lender has different loan limits and varying interest rates. For estimation’s sake, use the average interest rate, 9.34%, when calculating your payments.
- Evaluate your finances
- Check your credit score and determine whether you are in good financial standing to take out a loan. If your credit score is under 670, you may want to improve your credit first. If you have a decent credit score, a loan should be easy to secure. Create a budget and organize your finances to determine whether you can afford your estimated monthly payments with your other expenses.
- Compare loans
- Get an estimate from multiple lenders to ensure you're getting the best rate. Since rates vary by lender, it’s important to not accept the first offer before comparing to other lenders first.
- Prepare documents
- Most lenders require proof of employment, such as a paystub or social security card before approval. Make sure you have these documents readily available to avoid any delays.
- Accept loan
- Once you’ve compared loan offers and found one that’s suitable for your needs, accept the offer. Shortly after, you will receive your funds and begin making monthly payments.
How Do Personal Loans Affect Credit?
Personal loans can affect your credit poorly or positively depending on how you apply and manage the loan, as well as your current financial status.
If your loan application results in a hard inquiry, then it can leave a negative impact on your credit report for up to two years. Similarly, if you submit too many inquiries in a short period of time, this can also negatively impact your credit score. Soft inquiries, on the other hand, do not affect your credit score at all.
However, personal loans don’t strictly decrease your credit score. If you pay your balance on time every month, then your credit score will likely improve as a result.
Personal Loan Alternatives
If you find that a personal loan does not suit your financial needs, there are other options available. You could look into a 0% APR credit card, a personal line of credit or home equity line of credit instead.
0% APR Credit Card
A credit card that charges no interest over a set period. This option can help you consolidate credit card debt with a balance transfer or cover expenses through monthly payments.
- No interest for six to 21 months on average
- Typically, no annual fee
- 0% APR does not apply to every transaction you make on your card
- Possible fees for balance transfers
- Requires a good credit score for approval
Personal Line of Credit
This option is a hybrid between a loan and a credit card. If you are approved for a personal line of credit, you can withdraw cash as needed at any time and pay it back with a variable interest rate.
- Does not require collateral
- Pay back on your own terms
- Flexible, allowing you to take only the amount you need over time
- Only pay interest on what you borrow
- Higher interest rates
- Since it’s similar to a credit card, you only need to make minimum monthly payments for this option, making it riskier to fall into debt
Home Equity Line of Credit
Also known as HELOC, this alternative is considered a second mortgage with its own repayment schedule and term length. You can be approved for a large sum, such as $100,000, and only borrow $25,000. You will only be taxed for amount borrowed.
- There are tax advantages if you use funds for home improvements
- Only pay interest on what you borrow during draw period (your draw period is typically 10 years, and then you have 20 years to repay the balance)
- Requires collateral (typically your home), adding risk
- Lengthy approval process
- Closing costs and fees
6 Cited Research Articles
Annuity.org writers adhere to strict sourcing guidelines and use only credible sources of information, including authoritative financial publications, academic organizations, peer-reviewed journals, highly regarded nonprofit organizations, government reports, court records and interviews with qualified experts. You can read more about our commitment to accuracy, fairness and transparency in our editorial guidelines.
- Atkin, J. (2019, September 24). Personal Loan Interest Rates and APRs: What’s the Difference? Retrieved from https://www.experian.com/blogs/ask-experian/what-is-the-difference-between-apr-and-interest-rate-on-a-personal-loan/
- Bank of America. (n.d.) Cash-Out Refinance vs. Home Equity Line of Credit. Retrieved from https://www.bankofamerica.com/mortgage/learn/cash-out-refinance/
- Board of Governors of the Federal Reserve System. (2022, May 6). Consumer Credit - G.19. Retrieved from https://www.federalreserve.gov/releases/g19/current/
- Capital One. (2021, March 23). What Is a Credit-Builder Loan? Retrieved from https://www.capitalone.com/learn-grow/money-management/what-is-a-credit-builder-loan/
- Money Smart. (n.d.). Personal Loan Calculator. Retrieved from https://moneysmart.gov.au/loans/personal-loan-calculator
- White, A. (2022, March 30). How Do 0% APR Credit Cards Work? 8 Things to Know Before Applying. Retrieved from https://www.cnbc.com/select/how-do-0-apr-credit-cards-work/