What is a Personal Loan and How Does it Work?

Do you have expenses that you fail to pay on a regular basis? Or maybe a huge pile of high-interest debt requiring monthly payments that barely even cover the interest charges? What if there was a way for you to take out some money now to repay your debt, and be left with some lower interest rate loans?

Luckily for you, there is something JUST like that. It’s called a personal loan and can significantly help your personal finances if used correctly. However, if you aren’t careful, getting a personal loan could ADD to the debt you already owe on your credit cards and make it that much harder for you to achieve financial success.

This post will give you everything you need to know about personal loans covering topics including:

  • What is a personal loan?
  • How do personal loans even work?
  • If you want to get a personal loan, how do you apply for one?
  • What can you use a personal loan for and are there any restrictions?
  • How does taking out a personal loan affect your credit score? (and how does this change with whether you repay your loan on time or not)
  • Where can you get a personal loan from and where are the most reputable sources?
  • The pros and cons of personal loans

By the end of it, you’ll have a clear understanding of what exactly a personal loan is and whether or not getting one is right for you and your financial situation. Before reading on, however, do be advised that I am NOT a financial advisor and it is always a good idea to do your own research before making any sort of investment or financial decision.

That being said, let’s get into revealing just what a personal loan is.

What is a Personal Loan?

Put very simply, a personal loan is money that you take out from a lender which you’ll then repay in monthly installments over the course of 2 to 7 years. In other words, it is a type of credit that you can use but also must repay, just like mortgages, student loans, credit cards, or a home equity loan.

Typically, a personal loan will have a lower rate than other loans so they can be very useful for consolidating multiple sources of your debt into one easy monthly payment. Alternatively, if you’re thinking of making a big purchase but don’t want to save up a lump sum and instead want to break the payment up into monthly installments, a personal loan could be a great way to do it.

Financial institutions like banks and credit unions are the most common place where you can get a personal loan. Before getting further into how personal loans work, it’s important that you understand a few key concepts:

  • Principal – this is the initial amount of money that you take out from the bank or credit union. If you borrow $20,000 your principal is $20,000. Lenders usually charge you based on a rate applied to the principal of the loan.
  • Interest – lenders don’t give out money for free. How they make money is through something called interest which is basically the money you pay to them on top of your principal repayments.
  • Term – how long you have to repay the loan is called the term of the loan. Lenders will let you know what the term of your loan and interest is before you take one out.
  • Unsecured loan – with a mortgage or car loan, the house/car is what you’re putting up as collateral. This means if you fail to pay up, the financial institution can come for your property. Personal loans are typically unsecured meaning you don’t have to put anything down as collateral. This being said, if you trust in your ability to repay and are willing to put up some collateral, you can opt for secured personal loans instead of unsecured personal loans and could get lower rates from some lenders.
  • APR – annual percentage rate (or APR for short) is the amount of money you’ll need to pay outside of your principal per year as a percentage rate. This usually includes the interest rate plus any applicable fees that are in your repayment terms.

How Do Personal Loans Work?

Of course, a personal loan isn’t the same for everyone (hence the name “personal”). The terms you’ll get will depend on a variety of factors including your:

  • Credit score: this gives banks and credit unions an objective thing to measure each and every person who applies for a personal loan.
  • Credit history: maybe you’ve had a few unlucky breaks and your credit score isn’t the best. Don’t worry, your lender will also take into account your credit history so they’ll know if you’re consistently a poor credit user or if you have a pretty good track record overall.
  • Outstanding debt: how much debt you currently have also affects the amount that lenders will be willing to lend you. If you have mountains of debt already, it might be hard to get a loan without stipulations. On the other hand, if you have no debt owed, you’ll be viewed in a more favorable light.
  • Debt-to-income ratio: your debt-to-income ratio (or DTI for short) is calculated by taking all your monthly debt payments and dividing it by your gross monthly income. This ratio is used by lenders to gauge your ability to repay their loan. This being said, each lender will have different DTI requirements.
  • Free cash flow: the amount of money you have left over to make your debt obligations after paying off all your required monthly expenses is called free cash flow. This will also give lenders and idea of how much money you’ll have available to make monthly payments.

As mentioned above, most personal loans are unsecured meaning that you don’t need to put anything down as collateral. The issue is that lenders may look at all of the factors and decide that you don’t qualify for a personal loan. If this happens, don’t worry. There are a few more options to consider for personal loans like:

  • Secured loans – this is exactly what it sounds like. You’ll need to put something down as collateral which means that if you don’t pay up, the your lender can come and possess your collateral.
  • Co-signed loans – this means that someone with a strong credit score personally guarantees that you’ll make the monthly payments. If you don’t, they will be responsible for paying the lender.
  • Variable rate loans – these loans have variable rates and your monthly payments may change from month to month. A variable interest rate is different from a fixed interest rate that the lender decides how much money you owe them (outside of your premium) on a dynamic basis.

How to Apply For a Personal Loan

Despite all of the requirements and factors that your lender will check before giving you a loan, on your end, applying for a personal loan actually isn’t that complicated.

The first thing you’ll want to do is pre-qualify for a personal loan from multiple lenders. To do this, all you need to do is provide the lender some information like what the loan is for, how much you want to take out, some basic personal information, and your desired monthly payment. This prequalification process usually only takes a few minutes and allows you to compare offers from multiple lenders.

After you read through the loan terms of each offer, compare all of your loan offers and select the best one for you, you can start the formal loan application process. To do this, you’ll need to gather some documents. This includes:

  • Photo ID
  • Proof of employment
  • Proof of address
  • Educational history
  • Social security number
  • Financial information

This step can either be done in person or online. Most lenders now offer both options. After you complete this step, all that’s left to do is wait and find out whether your loan is approved or not. Once you’re approved, it can take as fast a day for the funds to arrive in your bank account.

What Can You Use a Personal Loan For?

The neat thing about personal loans is that you can use them for just about any purpose. As long as your credit is in good standing and the lender approves of your loan, they don’t really care how you spend the money. This is of course taking in into account the fact that they are expecting you to make the monthly payments in full.

Some common uses of personal loans are:

  • Debt consolidation
  • Home improvement projects
  • Medical bills
  • Refinancing existing loans
  • Paying for a wedding
  • Paying for a vacation
  • Funding any other large expense

As long as you know that you can repay the loan, you’re good to spend the loan amount however you best see fit. That being said, it’s recommended that you use your personal loan to help build your financial situation rather than add to your debt.

For example, investing in home improvements may be worth it if you know it will increase the value of your house dramatically and net you a positive gain. On the other hand, if you’re just going to buy a fancy depreciating toy like a car or boat, taking out a personal loan may not be the best idea.

How Do Personal Loans Affect Your Credit Score?

Like any other form of credit, a personal loan can work to either build your credit score or decrease it. It all depends on how responsible you are with repaying your loan.

If you make payments on time, your credit score will increase. On the other hand, if you’re constantly late with your payments or even miss a few, your credit score will drop.

On top of this, when you first apply for a loan, your credit score will be affected too. Almost all lenders will allow you to pre-qualify for a loan with a soft pull, which won’t affect your credit score. But then once you’re pre-approved and want to apply for real, a hard pull will definitely knock a few points off your credit score. Typically this won’t be more than 5 points and will only stay for 2 years.

Different Sources to Get Personal Loans From

The 3 main places to get a personal loan are:

  • Banks: big banks and financial institutions like Wells Fargo and Citibank usually offer personal loans. It could be the most convenient for you to stick with the current bank you’re with if you want to keep things simple so be sure to check if they offer personal loans.
  • Credit unions: local credit unions also usually offer personal loans. Some may even offer loans with more flexible terms than other lenders. Usually credit unions are where you’ll find the lowest rates.
  • Online lenders: more and more nowadays, personal loans are offered online. This offers you a super easy way to search for and compare multiples offers.

Because there are so many different sources to get personal loans from, make sure to do your own research and find the lender which will have the most favorable terms for you.

Pros and Cons of Personal Loan

How good a personal loan is for you largely depends on your own financial situation and how well you manage your own finances. That being said, there are some advantages and disadvantages of personal loans that generalize to almost everyone. It’s important to know these before diving headfirst into personal loans.

Pros of personal loans:

  • Gives you ability to make large purchase – if you have a large expense that you need to break up into smaller payments and pay it off over time, a personal loan is a great tool to use. This is especially true if you have a stable income and believe that smaller payments will be more manageable.
  • Allows you to consolidate your debt – consolidating your debt means taking various sources of debt and rolling them up into one monthly payment (thereby “consolidating” them). Typically, a personal loan will have a lower interest rate than most credit cards (which in turn have a higher interest rate than most other loans) so it could be a good idea to replace your high-interest credit card debt with some lower interest personal loan debt.
  • Build your credit score – just like with any other form of credit, when you make timely payments on your personal loan, you build your credit history and credit score. This can help you secure more loans in the future andbuild your trustworthiness in the eyes of the bank.

Cons of personal loans:

  • Lower your credit score – converse to the above point, if you miss your payments or fail to pay the required amount on your personal loan, your credit could be really negatively impacted. A lower credit score could signficantly hinder your ability to get future loans.
  • Charge off / collections – if you really fail to live up to your obligations, your personal loan may be “charged off” or go into collections. To have your account be charged off is for the lender to report your loan as a loss in their system. To have it go into collections means that the lender will sell your debt to a collections agency. Both appear as VERY bad things on your credit report.
  • Fees – even though personal loans typically do have lower interest rates than credit cards, you’re likely going to need to pay some fees to get them. This includes an origination fee, and a prepayment penalty.

Recap

So there you have it: a detailed article answering the question “what is a personal loan?” In this post, you’ve learned exactly what a personal loan is, how it differs from other installment loans like auto loans or mortgages, and the various pros and cons of personal loans.

Of course, be sure to do your own research before applying for any kind of loan. That being said, if used right, a personal loan has the ability to significantly transform your finances. Happy wealth building!

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