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Types Of Personal Loans And How They Work

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Published on August 2, 2022
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What do a luxurious Caribbean cruise and student loans with sky-high interest rates have in common? Both are a burden on your finances that a personal loan can help you afford.

Personal loans are an accessible, flexible funding method for almost any significant expense you’re facing. There are types of personal loans for almost any financial situation. Once you understand your options for personal loans, you’ll be able to tell which one is right for you.

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How Do Personal Loans Work?

Personal loans allow borrowers to acquire funding for various financial needs and wants, from debt consolidation to a vacation. Similar to a mortgage, borrowers usually start by shopping among lenders for the best loan available. Lenders don’t require collateral for personal loans and instead rely on your credit score and debt-to-income ratio when deciding what loan terms to offer you.

Taking out a personal loan will incur a monthly payment. The loan amount and interest rate will determine how much you’ll have to pay per month. Typically, personal loans have favorable interest rates, making them more affordable than other kinds of debt. However, as with most loans, personal loans often have origination fees that you must pay up front.

Different types of loans work better than others, depending on the situation. For example, although personal loans usually don’t involve collateral, some lenders also offer secured personal loans. If you have suboptimal credit, your lender might only offer you a secured loan because the collateral reduces their risk in lending.

You can find more details like this on the Personal Loan FAQs page.

Different Types Of Personal Loans

Each type of personal loan has pros and cons. Your unique situation will help you decide which will work best for you. 

Secured Personal Loan

A secured loan – as the name implies – secures the loan for the lender through collateral. If you default on your loan payments, the terms of a secured loan allow your lender to take possession of the collateral as payment.

Although secured personal loans require borrowers to risk an asset as collateral, borrowers can access reduced interest rates this way. Also, secured personal loans allow borrowers whose poor credit would otherwise prevent them from taking on debt to get a loan.

Unsecured Personal Loan

Unsecured personal loans are more typical than secured. Borrowers with sufficient credit (usually 600 or higher) can access unsecured personal loans. Your credit score will determine how much your lender is willing to loan you. Additionally, the better your credit score, the lower the interest rate you can obtain from your lender. However, unsecured personal loans rarely have as low an interest rate as secured loans.

Fixed-Rate And Adjustable-Rate Loans

Interest rates for personal loans come in two types: fixed-rate and adjustable-rate.

Fixed-rate loans have an interest rate that never changes. The permanent rate allows borrowers to always make the same monthly payment and not worry about a variable rate raising their payment out of the blue. However, fixed interest rates are likely not as low as adjustable interest rates can be.

Adjustable-rate loans (sometimes called variable-rate loans) offer borrowers an introductory period with an interest rate often lower than a fixed-rate loan. After the initial period expires, the interest rate adjusts and changes based on trends in the larger lending market. Preset caps and floors govern how widely your interest rate can increase or decrease.

Adjustable-rate loans are excellent for borrowers who can pay the loan off before the introductory interest rate expires. However, borrowers who plan on carrying the loan debt for its full term may find a fixed-rate loan more favorable, as it is not subject to rising interest rates.

Debt-Consolidation Loan

Debt-consolidation loans are a popular option for borrowers facing multiple debilitating debts. Ideally, debt-consolidation loans allow you to roll all your debts into one account that charges less interest than the original debts.

For example, they are often helpful for credit card debt and student loans. By making one affordable monthly payment, you can address your debt efficiently and avoid paying on multiple debts with severe interest rates.

However, debt-consolidation loans are only advantageous if they save you money. Therefore, it’s recommended that you confirm with your lender what interest rate they will charge you, whether the rate is fixed or variable, and what your monthly payment will be. Additionally, debt-consolidation loans cost origination fees, just like most other loans, so taking out a loan without doing your homework could be an expensive mistake.

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Revolving Credit

Revolving credit is another way to pay for expenses as you would with a loan. While revolving credit is not identical to a loan, it essentially acts as a reserve of funding that you can borrow against for a specific number of years. During the years you withdraw cash from the line of credit (known as the draw period), you usually only pay interest on the amount you borrow. Once the draw period expires, you will owe a monthly payment on your debt.

Unlike traditional loans, you can borrow against sources of revolving credit, pay back what you owe, and then borrow money again from the same line of credit. In addition, because you only pay interest during the draw period, you have more flexibility in repaying than with a conventional personal loan.

Popular kinds of revolving credit are a personal line of credit and a home equity line of credit (HELOC). Personal lines of credit require no collateral but may involve higher interest rates. HELOCs may offer larger pools of cash or better interest rates, but they require your home as collateral, putting you at risk of losing your home if you cannot repay your debt after the draw period.

Installment Loan

Unlike revolving credit, installment loans grant you one-time access to a certain amount of money given to you in a lump sum. After you receive the loan, you start making monthly payments on your debt that address the interest and principal.

Installment loans require a consistent monthly payment on the debt. While installment loans might not have as low of interest rates as revolving credit, they often come in smaller amounts. Additionally, if you can afford the monthly installments, you can have peace of mind knowing that after you make a set amount of payments, you will pay off the loan.

However, if you cannot pay the monthly installments, you will likely incur additional charges. Furthermore, if you don’t communicate with your lender if you think you might default on the loan or start missing payments, your lender may transfer the debt to a third-party debt collector.  They may also send information about the missing payments to any or all of the three major credit bureaus, negatively impacting your credit.

Other Types Of Personal Loans

Personal loans can range broadly in the lender providing them and how you can use them:

  • Wedding loans, usually unsecured loans for wedding expenses
  • Vacation loans, also unsecured loans for vacation costs
  • Home improvement loans
  • Medical loans for outstanding medical debts and costs
  • Cosigned loans, in which a cosigner’s credit lets you access a loan or better terms
  • Payday loans, which are not recommended due to exorbitant fees and little regulation

How To Get A Personal Loan

Now that you’re aware of the personal loans available, it’s vital to understand how to get a personal loan.

First, you’ll need a credit score of at least 600 to qualify for an unsecured personal loan. A lower credit score may mean you can only access secured or cosigned loans, and some lenders may decide not to work with you altogether.

After fielding offers from multiple lenders and choosing the one that suits you best, your lender will need personal documentation to move forward. You’ll supply them with a driver’s license or other official identification, proof of income and employment, and a utility bill or mortgage statement that verifies your address. Upon reviewing your documentation and financial information, your lender will decide the specifics of the loan they offer you.

You can apply for a personal loan online or in person if your lender has physical locations. Applying online is often faster and more efficient. Additionally, you can prequalify (which is a preliminary way for a lender to see if they would like to do business with you) for a personal loan with many lenders online.

The Bottom Line

Personal loans are versatile financial tools that allow you to afford a broad range of life expenses, from your dream vacation to ridding yourself of lingering debt.

Because personal loans come in many shapes and sizes, it’s crucial to understand the terms of the personal loan your lender offers you. The interest rate, monthly payment, and consequences for missing a payment or defaulting on the loan can vary widely depending on the type of personal loan and the lender you’re working with.

If you’re thinking about what a personal loan could do for you, apply for a personal loan with Rocket LoansSM today.

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Andrew Dehan

Andrew Dehan is a professional writer who writes about real estate and homeownership. He is also a published poet, musician and nature-lover. He lives in metro Detroit with his wife, daughter and dogs.