Understanding how personal loans work

Personal loans give you a one-time cash lump sum that you’ll repay in fixed installments. Often, borrowers with decent credit can get a lower interest rate than they would on a credit card. 

Even borrowers with weak credit have options for lowering their rates by adding a cosigner to the loan or putting up collateral.

Personal loan definition and how it works

A personal loan is a form of credit that allows you to borrow money that can be used for any purpose, from consolidating high-interest debt to buying a new household appliance to paying emergency medical bills. 

You might think of it like a credit card, except that with a personal loan you borrow a fixed amount—anywhere from $100 to $100,000—and receive it as a lump sum deposited into your bank account or as a check. A credit card, by contrast, is an open line of credit that you can continually borrow from until you hit your limit.

“One important advantage personal loans have over credit cards is a structured repayment schedule,” says Richard Barrington, a financial analyst at Credit Sesame. “This lets you know going in what the cost of the loan will be, and keeps you on track to pay it off over a defined period.” Each fixed monthly payment is part principal and part interest. Some loans come with upfront origination fees, which typically range from 1% to 5% of the borrowed amount.

You can apply for a personal loan through a bank, credit union, or online financial technology company (i.e., a neobank). The lender will evaluate your “past reliability with using credit and ability to repay a new loan,” Barrington says. It does that by pulling your credit score, credit report, and potentially your employment history.

A lender will also check how much of your income goes toward current debt payments, known as your debt-to-income ratio (DTI). If it’s high, it signals that you may already have too many debt obligations on your plate. 

All of these factors determine whether and how much a lender will offer you for a personal loan, and what the annual percentage rate (APR) and repayment terms will be. 

Neobanks, which offer banking or lending services through online or mobile platforms and don’t have physical branches, “may use less rigorous risk assessment models” than traditional banks, Barrington says. That means they won’t look as deeply into your finances. However, he adds, they could compensate for unknown risks by charging you a higher interest rate.

How quickly you can get a personal loan depends on the individual lender, but many are able to review and approve applications, and disburse funds, within days. “Borrowers should think long-term when borrowing,” Barrington says. “Ultimately, how fast you get the money is less important than how affordable your payments are and what the total cost of the loan will be.”

What are the different types of personal loans?

There are two main types of personal loans: those that are secured by collateral and those that aren’t. 

In general, a lender views a borrower as less risky when they are willing to put up collateral, such as a car or a savings account. If a borrower fails to repay the loan, the lender can repossess the collateral to recoup some or all of their loss. 

Here’s more about the different types of personal loans, and how interest rates are impacted.

• Unsecured personal loan: These are loans where you don’t have to give the lender any collateral. As a result, interest rates are dependent on credit history, and may be higher when a borrower’s credit score is low.
• Secured personal loan: A secured loan is less risky for a lender because the loan is backed by a physical asset (mortgages and auto loans are types of secured loans). Because of that, borrowers tend to see lower interest rates. 
• Cosigner loan: Some lenders let borrowers add a cosigner—someone with a strong credit history who agrees to be responsible for repaying the loan if the borrower stops making payments. Adding a cosigner can bring the interest rate down.
• Credit-builder loan: Someone with little or no credit history can have difficulty getting approved for any kind of loan, since the lender doesn’t have much to base its risk calculation upon. A credit-builder loan is a type of secured loan where the collateral is usually a cash down payment or a savings account. Barrington says it’s “not the most practical approach,” since the borrower is losing access to some cash while also having to pay interest on a loan, but it may be a necessary step for someone trying to establish or rebuild their credit.

What is a personal loan used for?

Personal loans can be used for anything. “This can be a blessing or a curse,” Barrington says. “In contrast, something like a car loan or a mortgage is used to purchase a specific asset that has a long-term value. Typically, the usefulness of that asset will outlive the time it takes to repay the loan.”

You can use a personal loan to pay for things with calculable long-term value too, such as making necessary improvements to your house or wiping out credit card debt that has a much higher interest rate than the new personal loan. 

“If you use a personal loan to consolidate credit card debt, make sure to completely pay off your loan before using your credit cards again,” says Kendall Clayborne, a certified financial planner at SoFi. “Far too often I see clients use a personal loan to consolidate their credit card debt, only to then start using their credit cards again, ultimately leaving them with twice as much bad debt to pay off,” she says.

But you can also use a personal loan to throw a wedding, take your family on vacation, or cover unplanned expenses. The key is to choose a loan with affordable payments, Clayborne says. “If the monthly payments are higher than what your budget allows for, you may not be able to keep up with the payments, ultimately hurting your credit score.”

Pros and cons of personal loans

Borrowing money always comes at a cost, but some strategies are cheaper than others. In that regard, personal loans often beat out credit cards. Not only are interest rates on personal loans generally lower for creditworthy borrowers, but they’re fixed for the entire repayment term, says Clayborne. Credit card interest rates can fluctuate multiple times a year. 

But personal loans have potential downsides. The fixed repayment schedule can backfire if you don’t have the cash flow to make a full payment in one month. Credit cards only require a minimum payment to keep your credit in good standing (although interest will still accrue and you’ll pay more in the long run).  

Here’s a summary of the pros and cons of personal loans.

Pros: 

• Predictable monthly payments
• Lower average interest rates than credit cards for creditworthy borrowers
• Fixed interest rates
• Potentially high borrowing limits
• Loan repayment ranges from one to seven years
• Typically don’t require collateral
• Funds can be used for anything 

Cons:

• Monthly payments are not as flexible as a credit card
• Interest rates can be high for borrowers with a low credit score or unreliable credit history
• May require collateral in order to secure a low interest rate
• Missing just one loan payment can damage credit score
• Approval may not be as quick as a credit card
• May charge fees for early repayment
• May charge an origination fee

The takeaway

Personal loans are a strong alternative to credit cards if there’s something you want or need to purchase but don’t have the cash to pay for right now. 

“In one sense, personal loans are probably an underused resource,” Barrington says. Their comparatively lower interest rates make them a better tool than credit cards for long-term borrowing, he says, since there’s no risk of snowballing interest. But like any loan, they need to be repaid. Failing to do so can result in a major hit to your credit score, and in the case of a secured loan, losing a physical asset.

Before applying for a personal loan, check your credit score and download your credit report from each of the three credit bureaus to check for errors. If you’re not set on using one particular bank or credit union, try a comparison platform to shop around for personal loan offers from multiple lenders.