What Are Personal Loans & How Do They Work?

What is a Personal Loan?

A personal loan is a flexible loan with short- to moderate-term repayment options and relatively quick approval and funding processes. Personal loans are sometimes referred to as “installment loans” because you pay the loan back in installments over time. They are typically unsecured, meaning there is no collateral required.

 

What Are Personal Loans Used For?

Personal loans can be a good option if you need to cover a big cost upfront, then pay it back in smaller installments over time. Many people take out personal loans to cover unexpected medical expenses, do necessary home repairs, or consolidate high-interest debt. You can use a personal loan for just about anything.

How Much Can You Borrow with a Personal Loan?

Personal loan amounts typically range from $500 to $10,000, though some can be much larger.

 

How Do You Decide If a Personal Loan is Right for You?

Personal loans may be a good option if:

• You are able to borrow the amount you need.
• You can afford the monthly payments on the loan.
• You like the idea of paying the loan back and being done with it (as opposed to a credit card, which allows you to continuously borrow up to the max amount).

How Do You Successfully Repay a Personal Loan?

Most personal loans have set repayment terms with bi-weekly or monthly payments. Loan terms, or repayment timelines, typically range from 12 to 84 months.

Here are a few tips that can help you successfully pay off your personal loan:

1. Determine whether the payment fits into your budget. Missing a loan payment or paying late can result in unwanted fees, so you want to feel confident that you can make the payments on time. Add the payment to your monthly budget and plan for it like any other fixed expense.
2. Pay attention to payment frequency.  Many personal loans require a monthly payment, but some do bi-weekly payments to line up with paychecks. For example, if your payment amount is $100, monthly payments would be $100. But if you pay biweekly, then you would pay $200 per month.
3. Pay more than the minimum when you can.  If you’re able to pay a little extra from time to time, you’ll speed up loan payoff and potentially pay less total interest. Before you do this, though, check to see if your loan has a prepayment penalty, which means you may incur charges for paying ahead of schedule.

Get a Personal Loan or Use Your Credit Card?

There are a few things to consider when deciding between a personal loan and credit card.

• Interest rate.  When comparing interest rates, look beyond the actual number that a credit card or personal loan is charging. Personal loans typically offer one fixed interest rate, so it’s relatively simple to calculate what your total interest cost will be. Credit cards often have variable interest rates, which means they are tied to a prevailing rate like LIBOR and can change over time. Credit cards may also offer low introductory rates that increase significantly after a specified period of time.
• Payments.  A personal loan payment covers interest and enough of the principal (amount borrowed) to put you on track for payoff within the loan term, or repayment period. A credit card minimum payment typically covers mostly interest, so you’ll want to make more than the minimum payment in order to chip away at your balance over time. 
• Flexibility. With a personal loan, you borrow a set amount of money with the understanding you’ll pay it off by a certain date. Credit cards, on the other hand, allow you to keep borrowing up to the maximum amount. That can come in handy if you need to borrow more than once, but it can also be a temptation to spend more than you need.

How Long Does It Take to Be Approved for a Personal Loan?

Personal loan approval takes a few minutes to a few days after initial application and credit check, depending on the loan amount and the lender. For higher loan amounts you can expect a longer and more detailed approval process.

For example, for loans in the $500 to $2,000 range, you could be approved within a day or two. If the loan is in the $5,000 to $10,000 range, it could take five days or more to complete the approval process and receive the funds in your account.

How Much Should You Borrow on a Personal Loan?

The typical personal loan amount ranges from about $500 to $10,000, though the number can be much higher. It’s typically best to only borrow what you need at a payment level you can afford. Remember the more you borrow, the more you’ll spend on interest.

What Costs Are Involved with a Personal Loan?

Consumers are sometimes surprised to discover the price of their personal loan is not just the interest rate. Knowing all the potential costs up front can help you feel confident you won’t be hit with any surprises during your loan term. Let’s take a look at some potential loan costs:

• Origination & Application Fees

An origination fee is an upfront fee a lender might charge to cover the cost of processing your loan. Not all lenders charge an origination fee, but if they do, it’s typically between 2% to 10% of the amount you are borrowing. The fee often depends on how large your loan is. If you have a small loan amount, the origination fee percentage will likely be higher than on a larger loan. Some states, like California, have laws that limit origination fees.

An application fee is usually smaller than an origination fee, ranging anywhere from $20 to $50. This fee is a set cost to process a transaction rather than a percentage of the loan amount. Not all lenders charge an application fee.

Some lenders may use the terms “origination fee” and “application fee” differently, likely due to varying regulations. Lenders often only charge one or the other, but they might charge both an application fee and an origination fee.

• Interest Rate

Interest rates for personal loans vary greatly, spanning from 5% to 300% depending on the amount and term of your loan and your credit score. A small loan amount with a short term will usually have a higher interest rate than a large loan amount with a long loan term. Take note: Lenders can charge interest on fees in addition to the actual amount borrowed, so look out for this.

• Loan Insurance

You may have the option of purchasing loan protection insurance to cover your payments in the event that you can’t make them — for example if you become unemployed. Loan insurance should not be a requirement for loan approval, but some lenders will try to add it on to a loan. It is not usually calculated into the annual percentage rate (APR) and can make comparing loan costs difficult.  For military borrowers, loan insurance must be included due to the Military Lending Act, and this is sometimes called the mAPR. 

• Prepayment Penalties

Some lenders charge a fee for paying off your loan before the end of the loan term. For instance, if you have a 60-month term, but pay your loan off at 48 months, you might be charged a prepayment penalty.

Why do some lenders penalize borrowers for paying early? After all, it’s better than paying late. The problem is the faster you pay off your loan, the less interest the lender receives. A prepayment penalty helps the lender recoup some of the money they planned to make on the loan based on your original loan term. Thankfully, most lenders don’t charge these fees, so you can usually prepay without incurring additional costs.

What is APR?

APR or Annual Percentage Rate is a way to measure the relative cost of multiple loans.  It is usually similar to the interest rate but can vary greatly on loans with fees and short repayment periods. As noted above, there are also some costs of a loan that may not be included in the APR of your loan.

What Happens When You Apply for a Personal Loan?

When you apply, your lender will typically do a full credit check, also known as a hard inquiry.  Some lenders may also request access to your bank account, to review your payment and income.  This allows them to see your payment history on accounts that are not reported to credit bureaus, such as utilities or cell phone payments.

Sometimes you may go through a prequalification process as well.  This means that the lender will do a light review of your credit to see if they think you will be approved for their loan.  The advantage to this for you is that you can compare with multiple lenders without a hard inquiry to your credit report before you decide on a loan.  Once you choose a lender and apply for the loan, you will go through the complete credit process and will have a hard inquiry added to your credit report.

Is a Personal Loan Good for Your Credit Score?

Making on-time payments on your personal loan can help boost your credit score if your lender reports to credit bureaus. But not all lenders provide information about their loans to credit bureaus, so be sure to check before you borrow. Be aware that even if they don’t report the loan and payments if you do not repay your loan, it may be sold to a third-party debt collector who does report the debt, which can hurt your credit. You might want to ask your lender whether they report to all three credit bureaus.

Your credit score may also drop temporarily when you first get a personal loan because it’s a new credit account and a new inquiry. However, the negative impact is usually temporary.  With on-time payments your credit score should go back up three to six months.

Regulation Considerations

Personal loans can vary in many different ways, partly because lenders are governed by different state or federal regulations. Banks are regulated by the federal government — either FDIC or OCC. Each state also has its own set of rules for licensed lenders that are not banks.

So, who can you ask for help when you need it?  If your lender is a bank, you can visit this site. Otherwise, start with your lender’s website.  Most reputable lenders will post information about who licenses them.

What to Remember About Personal Loans

Personal loans can be complicated, but you’re on the right track by learning how they work! To help, here’s a checklist of questions to reference as you make your decision:

• Can you afford the total cost?
• Are there extra fees?
• Do you understand all of the fees?
• How often are payments due?
• What is the interest rate?
• Does the lender report to the credit bureaus?
• Who are the lender’s regulators?

Keep these points in mind to feel confident you’re making the right financial decision.