What Is A Personal Loan And How Does It Work?

Taking out a personal loan can be a great way to cover an emergency expense, consolidate debt, invest in yourself, or finance a large purchase. First, you’ll want to understand what a personal loan is and how it can help you cover life’s unexpected expenses.

What Is A Personal Loan?

A personal loan is money you borrow from a bank, credit union or online lender and pay back in fixed installments. The loan can be used to pay for almost anything (with potential exceptions such as college tuition, a home down payment and business expenses).

For example, if you qualify for favorable loan terms, a personal loan could be a good way to fund a special event such as a wedding or graduation trip. Conversely, if you qualify for a low interest rate or poor terms, a personal loan may not be a wise financial decision. Consider getting prequalified for a personal loan, and discussing with a financial professional how a personal loan may fit into your overall financial strategy.

How Do Personal Loans Work?

A personal loan works much like a car loan: a lender issues you a lump sum that you then pay back with interest over a set term. Personal loan terms and amounts vary depending on the lender and the borrower’s financial profile, but common repayment terms are between 1 – 7 years, with average loan amounts anywhere between $1,000 to $50,000. Interest rates depend on the borrower’s financial health, but may range anywhere from 9% – 13% or above.

Personal loans are typically unsecured, meaning you don’t need to put up any collateral like a car or house to secure the loan. Instead, you qualify primarily based on your credit score and debt-to-income ratio (DTI). A higher credit score signals to lenders that you are a responsible borrower who makes their monthly payments on time and in full, while your DTI reflects your financial capacity to incur more debt.  

If approved, you must agree to loan terms such as the repayment period, interest rate, monthly payment amount and due dates, and any fees (for example, for loan origination and late payments).

Keep in mind that personal loan interest rates vary. They’re typically based on current prime rates with a margin added according to the amount of risk you pose to the lender.

For example, let’s say you need $10,000 to fund your upcoming wedding. A lender might approve you for a personal loan for that amount under the condition that you pay it back in monthly payments over two years at a specified interest rate: Starting from a prime rate of 5%, the lender determines that the risk of your defaulting on the loan (based on your credit score, DTI ratio, etc.) merits another 5% in interest, bringing the final interest rate to 10%.

What Are Personal Loans Used For?

So far, we’ve only scratched the surface on ways to use a personal loan. But truthfully, they can have many applications:

Debt Consolidation

Personal loans can be a great way to pay off multiple debts and simplify your repayment schedule to one loan, aka debt consolidation. For example, instead of trying to manage various debt from credit cards, utility bills, and medical expenses, you can pay them off with a personal loan and focus on a single monthly payment.

You can also use a personal loan just to pay down credit card debt. This can help lower your total interest costs as long as the interest rate on your personal loan is lower than your combined rates across credit cards.

Home Improvements

Want to remodel your house? A personal loan can provide the needed cash. Furthermore, home improvements can boost your home’s value and improve living arrangements. According to Remodeling Magazine’s 2023 “Cost Vs. Value Report,” some renovations recoup over 100% of their cost.

Unlike a home equity line of credit and other forms of home equity loans, personal loans are unsecured. This means they don’t require you to put up any collateral, so you can renovate your home without the risk of losing your house if you are unable to keep up with payments.

Unexpected Emergencies

Since personal loan funds are typically dispersed fairly quickly (sometimes the same business day they get approved), they can be a good option if you experience a sudden emergency, such as a car crash that leaves you with large medical bills or a natural disaster that damages your home and leads to unexpected repairs. 

Large Expenses

Other big expenses that could warrant a personal loan include family vacations, wedding expenses, moving costs, funeral arrangements, graduation trips, anniversary celebrations, and new furniture and home appliances — any reasonable expense that would deplete your cash reserves if you paid for it outright.

Personal Investment

You can also use a personal loan to invest in yourself. For example, you could use the money to start a business, pay for an online course, or get professional training. But make sure you have a clear plan for the funds. Otherwise, you could end up with a monthly payment from a personal loan and nothing to show for it.

How To Take Out A Personal Loan In 4 Steps

Should you choose to get a personal loan, follow these steps: 

1. Gather Your Paperwork And Information

Before extending a personal loan, lenders want to assess your creditworthiness, i.e. determine how risky it’ll be to lend to you. Consequently, you’ll need to gather documents that verify your income, such as pay stubs, tax returns, W-2s or 1099s, and bank statements.

Other information lenders typically request include proof of identity (a driver’s license or passport), proof of address (a lease agreement or utility bill), and other basic information (your birth date and Social Security number).

By preparing all of this information upfront, you can expedite the loan process and improve your chances of approval.

2. Compare Options And Get Prequalified

Next, compare different loan offers. Shop around online and at local banks and credit unions to find the best deal on annual percentage rate (APR) and other loan terms.

To quickly assess a personal loan offer, consider applying for prequalification. This gives you an estimate of how much the lender is willing to lend and under what terms based on your self-reported financial information.

3. Apply For And Receive Your Personal Loan Funds

Once you’ve prequalified for a personal loan, the application process is fairly straightforward — especially if you’ve already gathered the necessary documents. At this point, the lender will review your personal finances and likely run a hard credit pull with your social security number. Then they’ll approve or reject you for a personal loan based on your creditworthiness.

How long it takes to get a personal loan varies by lender, but generally, you can expect it to take a few business days to get approved and another few for the funds to hit your bank account (as a lump sum). That said, online lenders tend to be faster and may issue personal loans in as little as the same day.  

4. Begin Paying The Loan Back

Finally, be sure to read the fine print and understand the conditions of your personal loan, like how much you’ll be paying each month and for how long. That way, you don’t accidentally get behind and incur penalties.

You can also automate your finances by setting up autopay. This lets the lender pull the funds from your bank account when they’re due so you don’t have to remember to transfer them manually.

FAQs On Personal Loans

Here are answers to some frequently asked questions regarding personal loans:

Is a personal loan better than a credit card?

It depends. Personal loans can be ideal for large expenses that you prefer to pay off in predictable monthly payments, whereas credit cards can be better for small expenses you plan to pay off quickly. Personal loans also tend to have lower interest rates, but credit cards often have interest-free periods, during which you can pay off the debt without incurring any interest.

Will taking out a personal loan affect my credit score?

In the short term, taking out a personal loan can lower your credit score slightly from the lender conducting a credit inquiry. However, this is only temporary. In the long term, a personal loan can improve or harm your credit score depending on how responsibly you handle the loan. Timely monthly payments can boost your credit, while missed or late payments can hurt it.

What are some alternatives to personal loans?

Some alternatives to personal loans include home equity loans, cash advances, credit cards with 0% APR introductory periods, and borrowing money from family or friends. However, each has its pros and cons. For example, a home equity loan may offer a lower interest rate but requires you to put up your house as collateral. Similarly, a cash advance from your credit card may not require a separate application but could come at a higher interest rate.

What shouldn’t I use a personal loan for?

While personal loans can have many good uses, you shouldn’t use them to invest, pay for college tuition, or make a home down payment. This is because there are typically better financing options for these activities (like student loans and mortgages). Plus, some lenders may prohibit you from using a personal loan on certain activities.

The Bottom Line

Ultimately, personal loans can be a great option for consolidating debt, covering an unexpected expense, or funding a large purchase. But it’s important to weigh your options carefully and be financially prepared for the extra debt.

To check your capacity to take on a personal loan, download the Rocket Money℠ app. It can help you monitor your credit score and determine how much of a monthly payment you could fit into your budget.