Personal Loans: What They Are and How They Work

What to Know About Personal Loans 

Key takeaways: 

• Personal loans are loans that you can use for almost anything you want.   
• Personal loans are usually unsecured loans, which means that you’d qualify primarily on the basis of your credit.  
• Interest rates and terms of a personal loan vary greatly by lender.  

Simply put, a personal loan is money you borrow from a lender and pay back in monthly installments. If you are thinking about a personal loan, you’ll want to understand how it works, how you can use the proceeds, and the pros and cons. 

How Person Loans Work

A personal loan is typically an unsecured loan, which means it is not tied to an asset. Rather, a lender will issue a personal loan on the basis of a borrower’s credit profile. Borrowers must repay the amount borrowed – with interest. Rates can range from 6% to 36% – or even higher. They will vary by lender and are heavily dependent on credit scores. 

Personal Loan Uses

 
You can use the proceeds from a personal loan for almost anything. Some people use the proceeds to pay for home repairs, maintenance or renovations. Others pay outstanding medical bills, pay for a wedding or funeral, or make essential large purchases. 

There are several options for paying off credit card debt – including tapping into home equity and, for some people, debt settlement (resolution) – but personal loans are very popular. The idea is that you would take out a personal loan that has a lower interest rate than your credit cards. With the proceeds from the loan, you would pay off the balances on those high-interest cards. Then, you are left with one monthly payment to make, at the lower rate it carries. Because you are consolidating your existing debts to pay them off, this type of personal loan is often called a debt consolidation loan. 

For example, if you were carrying $3,000 in credit card debt, at a 20% rate, and made a minimum payment of interest plus 5% of the balance each month, it would end up costing $1,418 in interest alone – and take more than seven years to pay off.  Along with paying much more than the purchase price of what you bought, you lose the chance to do something positive with that money – like care for your home or save for retirement.  

In contrast, if you were able to obtain a personal loan at a 10% interest rate over 36 months, your payment would be around $97 per month – and include total interest paid of $485.  

Personal Loan Qualification

Lenders look at several factors in deciding whether to offer someone a personal loan.  

1. Credit history: Some lenders will require a certain number of years of credit history.  

1. Credit scores: Lower interest rates go to borrowers with higher credit scores. Some lenders will make loans to people with scores as low as 580. Many lenders require a score of at least 620.  

1. Debt status: Borrowers generally cannot be delinquent on current debt or have filed for bankruptcy recently. The timeframe will vary by lender.  

1. Debt-to-income (DTI) ratio: Lenders will look at a borrower’s income and debts, including mortgage (rent payments are usually not recorded), student loans, vehicle loans, credit cards, child support and alimony. Using these figures, they will calculate a DTI ratio: total monthly debt payments divided by monthly gross income. It’s the portion of your gross monthly income that goes toward paying off debt.  

Pros 

• Broad use: As discussed, you can use the funds you receive from a personal loan in any way you like. 

• Interest rates: Rates on personal loans are generally lower than those on credit cards but will vary by lender and credit scores. For homeowners considering a loan, a home equity line of credit or home equity loan could potentially offer lower rates. 

• Set payment schedule: Most personal loans have terms of 24 to 60 months. This means you must pay off the debt on a schedule. You can’t just keep making minimum payments, as you might on a credit card (and get into the situation where you’re paying on the debt for years and years). 

• Discounts: Some lenders offer discounted rates in situations with a co-borrower, or if the prospective borrower has a set amount of retirement savings.  

• Speed: Every situation is different, but NerdWallet reports that many lenders can deliver funding within a week.  

Cons 

• Debt: A personal loan involves taking on more debt. It is almost always better to save for large purchases, and to pay off existing debt with the help of a strong budget if you are able to do so.  

• Qualification: As explained, a consumer must qualify for a personal loan based on credit, income and debt. It could be difficult to qualify for consumers with lower credit scores, who are retired or who have fluctuating income.  

• Terms: The payment schedule that is a “pro” can also be a “con” for some borrowers. Payment schedules are strict. Any late or missed payment will have a negative impact on credit profiles and scores. 

• Origination fees: Personal loans usually come with origination fees that can range from roughly 2% to 7% of the loan amount. In addition, some lenders charge late fees and/or early repayment fees.  

Conclusion

Consumers thinking about a personal loan will want to make sure that they have a clear plan for using the funds, and that the monthly payments fit comfortably into their budget. Depending on your individual situation, you may find that a personal loan serves as a helpful tool in moving your finances forward.