How Do Personal Loans Work

Personal loans are offered by banks and online lenders, and can be used for a wide variety of needs, from making a home repair to paying for dental work. While it’s important to be careful not to become overextended in your borrowing, personal loans can open up new possibilities, act as a lifeline in tough situations and even help you repair your finances when you’re badly in debt.

The personal loan landscape is very active, with a wide range of lenderscompeting for borrowers. This means that you’re likely to be able to find a loan product that will work for you, even if your credit score leaves something to be desired. For those with good or excellent credit borrowing is often affordable and easy.

What is a personal loan?

A personal loan is a fixed amount of money given to an individual by a bank or other lender that comes with a fixed interest rate and a fixed repayment term.

Personal loans are unsecured, which means that there is no collateral involved. Because of that, the lender has little recourse if you don’t pay the loan back: they can’t, for instance, repossess your car the way they could if you failed to pay a car loan for which the vehicle served as collateral. Because the lender has no recourse, personal loan interest rates tend to be relatively high compared to secured loans.

Uses for a personal loan

Personal loans are extremely flexible; they can cover almost anything assuming you have a credit score that will inspire a lender to take a bet on you. There are many solid reasons for borrowing a bit of cash, including replacing an appliance, covering medical costs and paying for unexpected emergency expenses, to name just a few.

There are two rules of thumb to keep in mind when taking out personal loans:
Only borrow money you know you will be able to pay back in a timely manner.
Don’t increase your debt load for insufficiently important reasons.

Taking out a loan when you have no extra income to pay it back over time is a mistake — a potentially very costly one. It’s also probably not a good long-term financial strategy to pay for vacations, gifts or other luxuries with borrowed funds, even if you can pay the loan back on schedule. Instead, you could invest that money you’re paying in interest on the loan, improving your overall financial outlook.

One of the most common — and most strategic — reasons to take out a personal loan is to reduce higher-interest debt. Indeed, upwards of 60% of personal loans are used to consolidate debt or refinance credit cards, according to a study by LendingTree, which owns Student Loan Hero. Consolidating debt means paying off several debts with one new loan that has an interest rate lower than the average of the loans being paid off.

This tactic is intended to lower the overall interest you are paying on your debt, thereby reducing the amount you’ll end up paying and/or the time it takes to pay it off. You can use an online credit consolidation calculator to figure out exactly how much you could save. Consolidating debt also results in a single payment due every month instead of a cascade of payments, making managing your debt that much easier.

The different elements of a personal loan

The details of personal loans shift depending on the details of the situation, such as the borrower’s credit score, the amount being borrowed and the lender’s rate schedule. Here are some of the elements of a personal loan to consider as you’re shopping around:
  • Interest rate: The interest rate, usually given as a percentage of the loan
  • amount, is the amount you will pay on top of the principal of the loan. Interest rates for personal loans are usually fixed, meaning that the rate stays the same throughout the life of the loan. On occasion, rates can be adjustable, meaning they’ll fluctuate.
  • APR: The APR is the interest rate plus other fees that you must pay per year to borrow the loan, such as origination fees and service charges. This is basically the total annual cost of borrowing the money, and it can range from very reasonable to extremely high, depending on your credit score, typically varying between 7% and nearly 136%. In 2018, the average APR on personal loans was 33.52%, according to LendingTree.
  • Borrowing minimum/maximum: Lenders will often have floors and caps on how much they will lend in a personal loan. Typical personal loans range between $1,000 and $35,000, with some lenders offering much higher amounts to those with good or excellent credit. The average personal loan amount borrowed in 2018 was $10,575.
  • Term length: The term length is the amount of time the borrower has to pay the loan back. Personal loans usually have a fixed term, which means that all your monthly payments will be the same. Terms range from just a few months to six years or even longer. Three-year loans are the most popular, a LendingTree study found.
  • Prepayment penalties: Some loans come with the stipulation that you’ll be charged penalties if you pay the loan back entirely before the agreed-upon term is up. If you think you may want to pay your loan back faster than you are required to, it’s important to look at whether the loan you’re agreeing to has any prepayment penalties attached.
  • Other fees: Lenders can attach a variety of other types of fees to their personal loans, including origination fees and service charges. An origination fee is an amount you pay at the beginning of your loan for getting it set up; these fees usually range from 1% to 6% of your loan amount. It’s important that you read the fine print to know what fees you are responsible for once you sign on the dotted line.

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