What Is a Personal Loan? How Do They Work?

A personal loan is a type of bank loan that provides the borrower with a lump sum of cash.

The personal loan process begins with an online or in-person application. The loan amount, interest rate, and repayment term are established during the application process and outlined in the loan agreement.

Once you’ve received the funds or loan amount in your checking account, you’ll pay it back with interest in monthly installments for the length of the loan, which is called the repayment term. Personal loans often have relatively low fixed interest rates, making them ideal for covering major expenses.

Common features of personal loans

Personal loan amounts range from $1,000 to $50,000, while terms are usually 12 to 60 months.¹^,² With shorter loan terms, you’ll have higher monthly payments but pay less interest overall, while longer terms result in lower monthly payments but potentially more interest paid.

Each payment consists of principal (the amount you borrowed) and interest (the cost of borrowing).

The interest rate depends on your credit score, financial history, and current market rates. The average interest rate for a 24-month personal loan is 11.66%.³

Many personal loans are unsecured loans, meaning there’s no collateral for the lender to collect if you default. Therefore, their interest rates are typically higher than secured loans (like car loans or mortgages).

Personal loans can be used for a wide range of purposes. Here’s an overview of some common ways you can use personal loans.

Debt consolidation

A personal loan can help you consolidate high-interest debts like credit card balances or medical bills into a single, more manageable monthly payment. Debt consolidation can be essential to a debt management plan, helping you pay off your debts faster.

Using a loan for this purpose helps simplify the debt repayment process and can save you money on interest in the long run. Paying down high-interest debt can also help boost your credit score by decreasing your overall credit utilization ratio.

Emergencies

A personal loan can provide quick access to funds if you’re faced with an unexpected financial emergency, like an urgent home or car repair.

Although an emergency fund is the best option in this situation, a personal loan can be a good solution if you need more money than your savings can provide.

Medical expenses

You can’t always plan for unforeseen medical bills. A personal loan can cover a large bill following a medical emergency or elective procedure.

Using a personal loan for this purpose allows you to manage your health-related expenses without facing late fees or collections.

Home improvements

Homeownership can be expensive, especially when you’re faced with home renovation or repair projects.

A personal loan can help you pay to upgrade your kitchen, fix your roof, enhance your backyard, or replace your furnace without relying on credit cards or dipping into your retirement savings.

When you’re shopping around for a personal loan, pay attention to a few key factors to choose the best one for you:

• Interest rate. The interest rate significantly affects the overall cost of the loan. Look for a competitive interest rate – lower rates can save you money over the life of the loan.
• Repayment term. Choose a term that balances manageable monthly payments with reasonable interest payments. Keep your income ratio in mind; your loan repayments should be manageable with your current budget.
• Fees. Review the loan’s fee structure. Common fees include origination fees, prepayment penalties, and late payment fees. Origination fees typically range from 1% to 10% of the loan amount and are either deducted from the loan proceeds or added to the balance.4 When comparing loans, factor in these fees to understand the actual cost. But always look for loans with minimal fees and extra charges.
• Funding time. Time is crucial, especially if you need funds for an emergency. Look for lenders with a reputation for quick approval and disbursement of loan funds.
• Repayment flexibility. Check if the lender provides flexible repayment options. Some may offer the choice of monthly, biweekly, or other payment frequencies. Flexible repayment options can help you keep your budget on track.

With these details in mind, you can choose a personal loan that aligns with your financial goals and circumstances.

When you’re ready to apply for a personal loan, follow these steps:

• Check your credit. Lenders will use your credit score to determine the risk of you being able to pay back the loan on time. Review your credit report to see where you stand, and take steps to improve your credit score before applying if needed.
• Shop around. Compare interest rates, fees, and customer reviews for different lenders to find the one that best suits your needs.
• Complete an application. Once you’ve chosen a lender, apply and submit the personal loan requirements, like identification and proof of income (pay stubs and tax returns).
• Receive the funds. If your loan application is accepted, you can accept and receive your funds, which can take a few business days.
• Arrange repayments. Once you’ve received the funds, start making monthly repayments. Setting up automatic payments ensures you’ll never miss a payment and won’t be subject to late fees.

Even the easiest personal loans to get might not suit your needs. Luckily, there is more than one loan option when you need cash fast to pay for a surprise bill or a necessary home repair. Consider these alternatives before deciding on the best route.

Paycheck advance

Consider a paycheck advance loan if you need a small amount of cash. This type of loan lets you borrow against your paycheck and often doesn’t charge fees or require a credit check.

Credit cards

A credit card is another practical option for smaller expenses. Many credit cards offer 0% introductory APRs, allowing you to pay off the balance without incurring interest.

However, failure to pay off the balance within the promotional period could result in high-interest charges (and potential damage to your credit score).

Buy now, pay later loans

A Buy Now, Pay Later (BNPL) loan allows you to break down a purchase into smaller, often interest-free installments over a short period – typically weeks or months.⁵

However, you can only use a BNPL loan to fund certain purchases. If you need money for a specific bill or expense, BNPL may not be an option.

Home equity loan

If you own your home, consider a home equity loan, where you borrow against your home’s equity and use your home as collateral. A home equity loan provides a lump sum of cash with fixed monthly payments, and often has a lower interest rate than an unsecured personal loan.

However, if you default on a home equity loan, you risk losing your home. Therefore, only go this route if you’re certain you can make the payments on time each month.⁶

Home equity line of credit (HELOC)

Like a home equity loan, a HELOC allows you to borrow against the equity in your home. A HELOC is an open line of credit that lets you borrow money as needed during a draw period, which can last several years. Once the draw period ends, you enter a repayment period where you must repay any money borrowed during the draw period.

HELOCs are secured lines of credit, often with a variable interest rate. Like with a home equity loan, the biggest risk of a HELOC is losing your home if you default.⁷

A personal loan could be a good option if you need a large amount of cash to pay for a significant expense, like a bathroom renovation or an unexpected bill. It can also help consolidate debt and minimize your interest payments. However, personal loans aren’t the only option; consider credit cards, home equity loans or lines of credit, or paycheck advances.

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