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How Does a Personal Loan Work?

What is a personal loan, and how do personal loans work? Find out everything you need to know about getting a personal loan.

Have you looked into personal loans as a borrowing option? If you’re low on cash and need money to cover a large expense, a personal loan is a something to consider. While it would be ideal to have an emergency fund to tap for car repairs or extensive savings to draw on for a last-minute trip, many of us are still building our savings foundation. Borrowing money in the form of a personal loan is something to consider for these types of large expenses. So how do personal loans work? Here’s everything you need to know about personal loans.

how do personal loans work?

What is a personal loan?

A personal loan is a fixed amount of money borrowed from a lender that the borrower pays back with interest over the lifetime of the loan. Personal loans can be borrowed for a variety of purposes and are typically unsecured, meaning they aren’t tied to your personal property, like mortgages or auto loans are. You can apply for one through banks, credit unions, and peer-to-peer lending companies (like Prosper), one of the newer methods of personal borrowing.

In recent years, personal loans have grown in popularity. They are the fastest-growing form of debt, increasing by 18% in just one year. As of 2019, roughly 19 million people have a personal loan, and total balances are expected to increase by 20% by the end of the year. Although they aren’t as popular as credit cards, which are held by 176 million people, personal loans are appealing to consumers who are looking to manage their debt.

Personal loans vs. credit cards: What’s the difference?

As we mentioned, personal loans, like credit cards, are typically unsecured. This means that the lender can’t seize your assets should you fail to pay off your debt. For this reason, personal loans might carry higher interest rates than secured loans, which use some form of the borrower’s property as collateral.

If you have a smaller expense you have to pay, like a $500 veterinary bill, you might prefer to put it on your credit card, since you will likely be able to pay that off within a short time frame (a few months or less). Because credit cards charge 0% interest within the first 30 days of your purchase, the more you can pay back right away, the lower your overall cost will be. But with a personal loan, you begin paying interest on day one.

Personal loans, however, may be a better option for larger expenses—such as a special occasion or an elective surgery—that you need to pay down over a longer period of time. Some people may even choose to use the funds from a personal loan to pay off higher-interest credit card debt, although this approach would be most beneficial if you commit to not racking up more consumer debt. 

To determine whether credit cards or personal loans are better for your purposes, you’ll also need to compare annual percentage rates (APRs) and interest rates. Though these terms are often thought to be interchangeable, there is a slight difference in meaning.

  • APR: This is considered a more accurate assessment of the total cost to the borrower. It may incorporate an upfront origination fee, any other fees charged, as well as the interest rate. For some personal loans, an APR is set under the assumption that you won’t pay off the loan early. It’s important to read the fine print to understand what’s included in your APR.
  • Interest rate: This is the percentage interest charged by the lender to the borrower, excluding other fees.

How do these loans work?

Personal loans can have fixed interest rates, fixed payments, and fixed terms, which make them a viable option for many borrowers. Despite the popularity of credit cards, personal loans are beneficial because they typically have lower interest rates in addition to the fixed term options. 

You can apply for a personal loan through a variety of lenders, and you should expect to go through an application process as well as a credit check.

Traditional lenders include banks or credit unions, which offer personal loans from about $500 to upwards of $50,000. Peer-to-peer lenders are companies that connect individuals who need money with investors. As such, the application process may go faster than with a traditional lender. For example, at Prosper, people who get all the required paperwork in—and are approved—could receive their money in as little as two to three days.

Here is some additional information on each type of lender.

  • Banks: The longer you have used your bank, the likelier you are to get a better rate. But in many cases, you don’t need to be a current customer to apply.
  • Credit unions: These are non-profit financial institutions governed by their members, and they often offer better interest rates on personal loans to those members than banks might. While credit unions are community-based, you don’t have to work for the sponsoring organization to qualify for membership.
  • Peer-to-peer lenders: In recent years, lending platforms such as Prosper have emerged as a viable alternative to banks and credit unions and typically offer investor-funded, fixed-rate loans up to about $35,000 or more, for terms up to five years and beyond.

What are the typical terms?

Like credit cards, personal loans are granted in exchange for acceptance of a lender’s terms, which includes the interest rate charged, loan fees and payment deadlines.

Personal loans carry interest rates that are either fixed (meaning they’ll stay the same throughout the life of the loan) or variable (meaning they’ll change throughout the life of the loan). 

These could be as low as 6% or less, and as high as 36% or more depending on your creditworthiness (more on that below) and the lender’s policies. Because these policies can vary quite a bit, it’s important to be clear on what your loan terms are.

At Prosper, for instance, loans are fixed-term and fixed-rate, meaning that the terms (i.e, the length of the loan, typically three or five years) and the rates you agree to will never change throughout the life of the loan. There is also no pre-payment penalty, so if you find that you can pay the loan off sooner, you have the option to do so.

Unlike credit cards, personal loans may carry one-time origination fees of around 1% to 5% of the loan, which is taken out upfront and subtracted from the lump sum, so you need to factor that into the total amount you borrow.

Other personal loan fees may include pre-payment penalties, but many, if not most, lenders don’t charge these. But as with credit cards, most personal loans charge late-payment fees, so check with your lender for exact figures.

How am I evaluated for a personal loan?

Your lender will consider a number of criteria when evaluating you for a personal loan. For starters, you’ll have to fill out an application, which solicits personal information like proof of address, salary, employer name, employment history and current debts. Your lender will also look at your credit score, credit history and debt-to-income ratio. These will likely have the biggest influence on how favorable your loan terms will be.

What else should I consider in evaluating personal loans?

In addition to the interest rate, APR, loan terms, penalties and fees, borrowers should consider the following:

  • What you’re using this money for. Is this an expense you really need to cover now, or is it a goal you can continue to save for so you don’t have to take on additional debt?
  • How much money you’ll need. If you only need $500 to $1,000, it might make more sense to use a credit card and try to pay off the debt as soon as possible. Many personal loans start at $2,000.
  • Whether the payments are affordable—both month to month and in the long run. Make sure the terms of the personal loan are amenable to your financial situation and won’t strain your budget—otherwise, you may end up racking up the late fees. Also make sure to calculate what the total cost of the loan will be by the time you finally pay it off. Will the amount you ultimately pay in interest throw you off your various financial goals?
  • Whether the lender is a credible institution. Be wary of fraudulent lenders who promise you quick cash and low interest rates in exchange for big upfront fees. Vet potential lenders by checking their websites for license or registration information or by checking to see if the lender is listed with your state’s Department of Banking or Financial Regulation.
  • The fine print. Be sure to read all loan documents carefully and make sure that you understand interest rates and loan terms. If you have any questions or concerns, don’t hesitate to ask your lender for further clarification.

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