How Do Personal Loans Work?

A personal loan provides you with a lump sum of money upfront that you pay back over time. Personal loans can help you cover large purchases or unexpected financial issues, such as a car repair, home renovation project, or medical expenses.

You could also qualify for a lower interest rate on a personal loan compared to a credit card. The average interest rate for a two-year personal loan was 12.33% as of August 2024, according to the Federal Reserve, while a credit card’s average rate was 21.86%. But keep in mind that the rate you get depends on your credit profile.

What is a personal loan?

A personal loan lets you borrow money when you need funds to cover a big purchase or expense. The cost to borrow money with a personal loan is expressed as the loan's annual percentage rate (APR), which is the interest rate plus any upfront fees. 

And payments are generally made in fixed monthly payments — meaning the monthly payment won't change over the life of the loan. You can get a personal loan from a bank, credit union, or online lender, and funds may be available as soon as the same day you apply or the next business day, in some cases.

Personal loans can be used for a variety of purposes, including:

• Home improvements and upgrades
• Life events, like a wedding or funeral
• Moving costs
• Dental expenses
• Medical bills
• Debt consolidation
• Credit card refinancing
• Unexpected expenses

You may also be able to use a personal loan to fund a special trip, a new car, truck, or boat. Most lenders ask what you intend to use the loan for, as some loan purposes are generally restricted — like paying for college tuition or a down payment on a home.

How does a personal loan work?

When you take out a personal loan, you receive a lump sum that you pay back over time with interest. Personal loans may have lower interest rates than credit cards, which can make it more affordable to borrow for big-ticket items or expenses. 

Terms are usually between 1 and 7 years, with some lenders offering longer terms in some cases. Longer terms can shrink your monthly payments, but they’ll cost you more in interest, while shorter-term loans may have a higher monthly payment for the same amount borrowed, but less overall interest.

Interest and fees

In addition to interest, some personal loans charge an upfront fee, often called an origination fee or sometimes an administrative fee. This fee can range from 0% to 12% of the loan amount, depending on the lender and your credit profile. There are a few things to know about origination fees:

1. They're often deducted upfront from the loan amount.
2. The origination fee is accounted for in the loan's APR, which is why it's best to compare APRs over interest rates.
3. The better your credit score, the easier it is to avoid origination fees.

If you make late payments or have insufficient funds in an account from which a payment is made, you may also be charged late fees and/or NSF fees. However, some lenders, like SoFi, charge neither late fees nor origination fees.

Check Out: Best Personal Loans With No Origination Fee

Qualifying for a personal loan

To qualify for a personal loan, lenders usually consider your credit history, income, debt-to-income ratio (DTI) — your existing monthly debts (credit card balances, auto loans, mortgages, and so on) compared to your gross monthly income — as well as your employment status.

But before you apply, prequalify. Prequalification is a way to get a sense of the loan types and rates you might qualify for without submitting a full, formal application. It won't hurt your credit, and can show you rates and terms that specific lenders think you'll qualify for. 

You'll generally need to provide at least your name and contact information, as well as the loan purpose, loan amount, and sometimes your Social Security number (or the last four digits). 

Note that once you go through the full application process (prequalification only takes a few minutes and doesn't require documentation), the lender will conduct a hard pull on your credit, which could ding your score by a few points, usually for no longer than one year. 

Types of personal loans

There are generally two types of personal loans available:

• Secured loan: When you take out a secured personal loan, you provide the lender with collateral, usually in the form of money or personal property (such as your home or car). If you default on the loan, your lender can take your collateral.
• Unsecured loan: Unsecured personal loans can be acquired without any collateral. Lenders determine approval based on factors such as your DTI (lenders typically prefer under 35%), credit history, and income. Because collateral isn’t required to secure the loan, these types of loans usually have slightly higher APRs if you don’t have a good credit score.
• Cosigned personal loans: A cosigner is someone who promises to repay the loan if you can't. Lenders may be more willing to approve your loan application or lower your rate if you apply with a cosigner with good credit. But if you make late payments or default, not only will your cosigner be on the hook for what you owe, but their credit could suffer. A cosigned loan can be either secured or unsecured.

Bad-credit loans

Designed especially for borrowers who have bad credit or no credit, they can be easier to obtain if your credit score is low or nonexistent, but your APR will likely be higher as a result. Consider getting a cosigner if the higher APR is too costly. 

Some bad-credit loans can be predatory, such as payday loans. These loans have sky-high APRs, which can be 400% or more, depending on where you live, and typically charge $10 to $30 for every $100 borrowed. They’re short-term two- to four-week loans with maximum loan amounts up to $500, generally.

The problem with these loans is that they can be hard to pay off on time when you're already short on funds. This can lead you to renew or rollover the debt, which can then lead to more fees. Payday loans can end up being quite costly and should be avoided.

However, there are other options, like payday alternative loans (PALs), which are offered by certain federal credit unions to their members as a legitimate alternative to payday loans. Loan amounts may be available up to $2,000, depending on the type of PAL, and APRs are capped at 28%. Even if you're not currently a credit union member, some offer PALs to new members as soon as they join. 

How to compare personal loans

When you’re ready to borrow, prequalify for a personal loan with multiple lenders first. It own't impact to your credit score and can help you compare loans before submitting an application. 

However, prequalification is not an offer of credit, and your final rate could be different. 

Here’s what to look for:

• APR: When comparing interest rates, lower is always better. However, instead of only comparing interest rates, compare the APR. Because APRs factor in upfront fees like origination fees, as well as the interest rate, using the APR as a benchmark will make it more of an apples-to-apples comparison between loans.
• Fees: Keep in mind that you may be charged fees (such as origination, application, or late fees), and this could add to your borrowing costs.
• Repayment terms: Your repayment term is the amount of time you have to repay your loan. Shorter terms usually mean higher monthly payments, while longer terms can lower your payments (but increase your overall borrowing cost, due to interest). Consider how long you’d prefer to repay your loan, and keep in mind your budget while comparing options. It’s usually best to pick the loan with the lowest APR with a monthly payment you can comfortably afford.
• Time to fund: If you need money fast, how soon the lender can deliver it is important. Many lenders fund personal loans within a few days of approval, and some offer same-day personal loans. If you need a personal loan for an emergency, it could be worth paying a slightly higher APR to get one.
• Perks: Did you know some lenders offer perks, too? You may score a better APR when choosing a lender you already have a relationship with. Or you might gain access to perks like free credit scores, hardship forbearance, or even job placement assistance if you find yourself out of work. Perks don’t always make up for high interest rates or other drawbacks, but they could be a deciding factor when comparing two similar loan options.

Learn More: How To Compare Personal Loans

How to apply for a personal loan

To apply for a personal loan, follow these steps. You’ll want to have your financial information handy, along with your driver’s license and Social Security number, as many lenders require it. 

You’ll likely need to be over the age of 18 (or the age of majority in your state) and a lawful resident of the U.S. as well.

1. Check your credit: Before you begin loan shopping, check your credit report for an idea of what lenders will see when you apply. You’ll also want to correct any errors that could be dragging down your credit score.
2. Know your existing debts: Lenders may want to know your debt-to-income ratio to get a feel for whether you can take on any more debt with your current budget.
3. Check rate quotes: With this financial information in hand, shop around for rate quotes by prequalifying. This lets you know what interest rates and loan terms you might qualify for and where you're more likely to be approved.
4. Fill out the application: When you find a lender that suits your needs, start the application. Many lenders offer fully electronic applications, which can speed up the process (and you may get approved faster, too). Read over your answers carefully to make sure you’ve included all the required information. From here, the lender will perform a hard credit inquiry, which will lower your score temporarily.
5. Upload documents: You may need to provide financial documents that show your income, assets, and debts, such as bank statements or pay stubs. Your lender will notify you of what documents you need and how to submit them.
6. Receive funds and begin making payments: If you’re approved, you should receive your funds shortly after — sometimes as soon as the same or next business day. Once you receive the money, you can put it toward your bills or expenses. Don’t forget your monthly loan payments; you might even get a rate discount if you arranged for automatic payments from your bank account.

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Personal loan alternatives

As useful as personal loans can be, they’re not the right fit for everyone. Here are some alternatives that might work better for your situation.

• Credit card: If you need a small amount of money for a short period of time, consider getting a credit card. Keep in mind credit cards have relatively high interest rates (21.86%, on average, according to the Fed). Credit cards also have variable interest rates, which fluctuate based on market conditions. This means your rate can change, along with your monthly payment.
• Personal line of credit: Unlike a personal loan, but similar to a credit card, a personal line of credit is a revolving account that lets you access your funds up to a certain limit. You may also have to pay a fee each time you access the account. Lines of credit are typically unsecured and come with variable interest rates as well. You can find personal lines of credit at banks or credit unions.
• Tap into your home equity: A home equity loan or home equity line of credit (HELOC) is a way to borrow against the value of your home. These kinds of loans can be used to cover big expenses like debt consolidation, home remodels, or college tuition, and usually have lower interest rates than credit cards plus long repayment periods. Unlike a personal line of credit, both are secured by your home. If you default, you could face foreclosure.
• Cash-out refinance: Another way to use your home to get the cash you need is a cash-out refinance. This is a way of refinancing your mortgage, plus an extra amount of cash you receive at closing that you can put toward your bills, purchases, or expenses. Keep in mind that this could extend the length of your mortgage and can change your interest rate, plus put you at risk of losing your home in the event of default.
• Payday alternative loans: As mentioned, these loans are a good fit for bad- or fair-credit borrowers. As alternatives to payday loans, the APR is capped at 28% with loan amounts up to $2,000.
• “Buy now, pay later” services (BNPL): These services allow you to make your purchase now and pay later, usually in fixed installments in 3-, 6-, or 12-month terms. Some even permit 0% interest if you pay off your balance with a payment every 2 weeks for 6 weeks.

Learn More: 9 Personal Loan Alternatives

Read More:

• How To Get Approved for a Personal Loan
• Best Personal Loans
• Best Personal Loans for Fair Credit
• Best Personal Loans for Good Credit
• Best Banks for Personal Loans
• Best Credit Unions for Personal Loans