How Do Personal Loans Work?

8 Min Read
Updated Feb. 23, 2024
Written By
Scott Steinberg
Asian woman budgeting with a calculator and her laptop at home.

Perhaps you’re looking for a personal loan to pay for home improvements, an alternative to credit card debt or to consolidate overall debt. Then again, it could just help to have a little extra spending money around to help cover everyday expenses. In any event, personal loans can help you put cash in your pocket fast.

But before you do that, it’s a good idea to know how personal loans work, the types that are available and how you can apply for one.

How Does A Personal Loan Work For Borrowers?

A personal loan is a form of installment loan. Banks, credit unions, online lenders and other financial institutions grant them to qualified borrowers. With personal loans:

  • You borrow a lump sum upfront and agree to repay what you owe in fixed-monthly payments over the course of the loan term.
  • You pay back the loan at a fixed interest rate or annual percentage rate (APR).
  • The repayment period ranges from 2 – 5 years.

What Is The Interest Rate For A Personal Loan?

The amount you can anticipate paying in interest will vary based upon your individual credit score, credit history, terms and conditions and financial lender. On the bright side, your interest rate should remain at a fixed rate for the duration of the loan. This means that, even in a volatile economy, you needn’t be concerned about sudden increases in interest rates raising your monthly loan payments.

How Quickly Can You Get Your Money With A Personal Loan?

One perk of personal loans is that funds are typically sent your way soon after loan approval, sometimes as quickly as within the same day. After sums have been paid out from the loan and these monies are in your possession, your repayment timeline will go into immediate effect.

When Do You Need To Start Repaying Your Personal Loan?

Once you’ve signed your paperwork and received your payment, your lender will expect you to consistently make your agreed-upon monthly payments. While some personal loans allow for early payment at no charge, others may apply prepayment penalties if you pay them off too early.

See What You Qualify For

What Are The Types of Personal Loans?

There are many uses for personal loans including home improvement, debt consolidation, emergency expenses and more. However, from a lender’s standpoint, there are two types of personal loans that you can obtain as a borrower: unsecured and secured personal loans.

Unsecured Personal Loans

Unsecured personal loans don’t have to be backed by collateral, meaning that you won’t have to put your vehicle or real estate property at potential risk to obtain one. Your lender will look at factors such as your credit score, credit history, debt-to-income (DTI) ratio and other factors when deciding whether or not to extend a loan to you.

For most borrowers, unsecured personal loans are the most common types of personal loans that tend to be issued today.

Secured Personal Loans

Secured personal loans are backed by collateral, which means that they require borrowers to secure the loan against items such as their car or house to qualify. If the borrower defaults on the loan, the lender can then repossess these items to help offset the outstanding balance.

Secured loans are generally offered by lenders if you have a lower credit score or less credit history, because lenders view these as an indicator of a higher lending risk.

How Does The Personal Loan Application Process Work?

If you’re securing a personal loan for yourself, you’ll need to apply for a loan and be qualified to obtain it by a financial lender. On the bright side, applying for a personal loan is a straightforward process. It begins by reaching out to a lender.

Steps involved in the process often include:

1. Get Prequalified By Lenders 

Each financial institution will offer loans on its own terms and conditions. Each will also vary in the amount of money that it’s willing to lend to borrowers. Do your homework and research here. Shop around for different offers.

As part of your legwork, compare options from a minimum of three places. Doing so can help you get a better sense of what APR, loan terms and loan amount that you can secure, and which is the best offer for you.

Getting prequalified for loans can aid with the decision-making process. After all, doing your research can help better ensure that you choose the right loan and lender.

2. Gather And Submit Information And Documents

Having decided on a specific loan and lender, you’ll next formally apply for the personal loan. This means that you’ll have to qualify with a lender and demonstrate your creditworthiness and ability to repay the loan. Before submitting the loan application, spend some time gathering paperwork that helps support your case.

Having begun the application process, lenders will then review your credit history, credit score and DTI ratio to see if you meet eligibility guidelines. They’ll also take a closer look at other pieces of information such as your current employment status, income and expenses to determine what loan amount to extend to you.

Lenders will keep an eye out for borrowers who possess a strong credit history, good credit score and enough financial liquidity to pay off any monthly balances.

3. Agree To Your Loan Terms

Should a lender decide that you are creditworthy, and that it wishes to qualify you, it will propose specific conditions for you to agree to. These conditions will include a well spelled out timeline for loan repayment and set of loan terms for mutual agreement.

4. Receive Your Personal Loan

If your application for a personal loan is approved, your financial lender will transfer any monies that you’re cleared to borrow to your personal account. You can expect to see them within a matter of days, or even the same day, depending on the terms of your agreement and policies of your financial lender.

5. Start Repaying Your Loan

Should you enter into the personal loan contract, it’s important to make timely payments going forward for the life of the entire loan. If you fail to do so, it may negatively impact your credit score, credit history and future ability to obtain financing.

What Are The Alternatives To Personal Loans?

If you’re looking to get your hands on additional money, other financing options may be available depending on whether you own a home or not.

Alternatives For Homeowners

If you own a home and have equity available, you could use a cash-out refinance, home equity loan or home equity line of credit (HELOC). Many borrowers may opt to take out a HELOC instead of a personal loan, as they’re not obligated to spend all the funds or make additional payments on any money they don’t use.

Alternatives If You’re Not A Homeowner

If you don’t own a home or have enough home equity, some other alternatives to personal loans may include low-interest balance transfer credit cards.

Likewise, other lending or credit options may come with lower interest rates attached than personal loans. For example, if you’re looking to finance something specific like medical debt or an auto loan, you may be able to get a loan specific to your need at a lower interest rate.

Personal Loan FAQs

Have more questions about personal loans? We have answers.

When does it make sense to use a personal loan?

You may be wondering, should you get a personal loan? It might make sense to consider a personal loan rather using a credit card as your rate may be lower. While there are many reasons to use a personal loan and reasons not to, the key thing to remember is that you’re taking on a debt and should make sure your budget can handle the payments.

Can personal loans impact my credit score?

Borrowers should be aware that personal loans and their servicing are reported to major credit bureaus. This means that they can have a positive impact on your credit history and credit score if you repay them in a responsible and timely manner. At the same time, if you default on the loan or have numerous hard inquiries, it may negatively impact your credit score and credit history as well.

What’s the difference between interest and APR for a personal loan?

Your APR will help determine how much you will pay over the life of the loan. It includes your interest rate, expenses paid to the lender for the servicing of the loan, and may come with prepayment penalties, origination fees and other fees attached. An interest rate doesn’t factor in these lender fees and therefore doesn’t include the total cost of borrowing the loan.

The Bottom Line

Life is often full of surprises, which can come at an unforeseen cost. A personal loan can come in handy in these situations. The cost for taking one out is that you’re agreeing to not only pay it back, but also pay interest and additional fees for 2 – 5 years to come.

That’s why it’s important to keep up with your financial obligations and make timely payments as well to ensure the healthiness of your credit history and credit score.


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