What is a Personal Loan?

Updated: 29th Aug 2021 Written by Jordan Blansit
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Whether you want to pay for the wedding of your dreams, take the vacation of a lifetime, or build your small business from the ground-up, personal loans can make it happen.

But before you go into debt to fund your future, you should understand what you’re getting into, from the jargon used to the terms and conditions of repayment.

What is a Personal Loan?

A personal loan is a type of installment loan that comes with fast funding, nigh-unlimited usage options, and a repayment term of a few years or less.

While they can be expensive compared to other types of debt, their flexibility makes them a desirable lending option if you need quick cash for a variety of financial needs.

How Do Personal Loans Work?

Personal loans may come as secured or unsecured debts.

Secured loans require you to put up your house, car, savings account, or other items of value as collateral against your debt. In the case of default, the lender has the right to repossess and sell the collateral property to recoup their losses.

But most personal loans are unsecured (also known as good faith or character loans), which means they’re not backed by collateral.

Lenders designate unsecured loans based on an applicant’s credit score, debt-to-income ratio, and free cash flow. Some lenders may also provide unsecured loans to bad credit borrowers who bring along a cosigner.

Personal loans may also come with fixed or variable interest rates. A fixed-rate loan carries one interest rate for the life of the loan, with interest bundled into the borrower’s monthly payments.

But variable rate loans may see fluctuations in the interest rate over time, which can affect a borrower’s repayment obligation (for better or for worse).

What Can I Use a Personal Loan for?

Unlike auto or student loans, personal loans can be used for anything you want – except buying a car or education, of course.

One popular usage is to consolidate numerous high-interest debts into a single sum with a regular monthly payment. But you can also use your personal loan to:

  • Cover medical bills
  • Pay for wedding or vacation expenses
  • Renovate your home
  • Compensate your lawyer for legal costs
  • Fund your small business or startup
  • Upgrade your furniture or appliances

When is a Personal Loan a Good Idea?

While you can use a personal loan to meet almost any need, that doesn’t mean you should.

Usually, it’s best to reserve taking out a loan for emergencies or improving your financial standing.

For example, using a personal loan to consolidate your debts may let you save on interest and pay less in the long term.

Or, if you used a loan to cover home renovations, you could boost the value of your property when it comes time to sell.

Moreover, if life happens and you find yourself on the receiving end of an unexpected emergency bill, such as from the ER or your car mechanic, a personal loan can get you through such trying times.

When is a Personal Loan a Bad Idea?

But personal loans aren’t always a good idea.

For example, if you have a spotty history with financial responsibility, taking out a loan may merely provide a new opportunity to ruin your credit.

And if you have access to alternatives, such as a low-interest credit card, a no-interest repayment plan (such as for your hospital bills), or even a cash advance on your paycheck, the terms may prove more favorable than a personal loan.

You may find the same true of HELOCs (home equity lines of credit) or a home equity loan, as well.

Lastly, if you ever find yourself staring down the barrel of a no-credit-check loan, run. These predatory loans come with high interest rates and often require collateral, such as your house or car.

For most poor credit borrowers, a credit card, credit-building loan, or other types of debts will satisfy your needs at least as well.

Personal Loan Terms to Know

When you take out a personal loan, there are several terms and features to keep in mind. And if you’re as scatterbrained as I can be, it’s a good idea to have a list at hand before you sign the dotted line.

Annual Percentage Rate (APR)

APR is the cost of borrowing money from a given lender. This number – expressed as a percentage – lumps your fees and interest together to provide a snapshot of your total annual borrowing costs. Rates may range from just 5% to over 36%.

Automatic Payments

If you’ve ever set up automatic bill pay for your credit card or utilities, you’re familiar with automatic payments.

This is an amount that automatically transfers from your bank account to pay off your debt at regular intervals.

Collateral

Collateral is any property of value that you put up against the loan, such as a savings account, house, or car. If you default, the lender may repossess your property to cover your debts.

Default

When you default on a loan, that means you’ve failed to repay the loan according to your contract.

A default shows up as a negative mark on your credit report – so avoid them if at all possible.

Delinquent

If you miss payments or make a late payment, you’re considered delinquent until you’re caught up again.

Fixed Interest Rate

A fixed interest rate is an interest rate that never changes, regardless of economic circumstances.

Lender

The lender if the person or institution that loans you money.

Loan Term

The loan term is how long you have to repay your debt. Your creditworthiness determines the length of your term, which in turn determines your monthly payment obligation.

Monthly Payment

Your monthly payment is how much you’re required to pay each month according to your contract. Typically, it’s wise to pay a little extra if you can afford the cost.

Origination Fee

Some lenders charge an origination fee – deducted from your loan total – for processing and approving your loan.

Peer-to-Peer Lending

Peer-to-peer lending occurs when you get a loan from an individual or investor without an intermediary financial institution.

Peer-to-peer, or P2P, platforms and lending services are widely available online.

Prepayment Penalty

Some lenders charge a prepayment penalty for paying off your loan early. This penalty helps lenders recoup some of the “losses” incurred by receiving fewer interest payments. If possible, avoid lenders who charge prepayment penalties.

Prequalification

When you shop around for lenders, many allow you to prequalify for a loan, which involves submitting a short application and undergoing a soft credit check.

This lets lenders provide an estimate of your loan amount, APR, and term so you can compare lenders side-by-side.

Note that prequalifying does not guarantee approval or your final loan terms.

Prime Rate

The Prime rate is the lowest interest rates charged by commercial banks. Many lenders use the prime rate plus an additional percentage to determine your actual interest rate.

Principal

Principal is the amount you borrow from the lender, excluding interest.

Variable Interest Rate

A variable interest rate fluctuates during the loan term based on movements in the economy and prime rate.

Your loan agreement should specify how the rate is determined and what may cause it to change.

Types of Personal Loans

Personal loans come in several different flavors. As such, it’s important to know your options – and which you prefer.

Installment Loans

An installment loan is a lump sum that you pay off in fixed, monthly increments over time. Personal, auto, and home loans all count as installment loans, among others.

Secured Loans

Secured loans are backed by collateral, such as your house or savings account, to protect the lender in case of nonpayment.

Unsecured Loans

Unsecured loans require only your signature as your promise to repay your debt. Typically, these loans are considered riskier for lenders, leading to higher interest rates overall.

Where Do I Get a Personal Loan?

Many banks, credit unions, and online lenders provide personal loans to all manner of demographics.

You may also look into specialized services, such as peer-to-peer lending platforms, as potential loan providers as well.

Keep in mind that it’s always acceptable to shop around for rates and terms that meet your needs.

Be on the lookout for reputable lenders that offer low interest rates, favorable repayment terms, and collateral requirements within your comfort range.

How to Qualify for a Personal Loan: What Factors are Considered?

There are personal loans available for almost every type of borrower – but not all are created equal.

Still, most consider the following factors when determining a borrower’s creditworthiness and potential interest rates.

Income

One of the biggest factors in whether a lender will loan you debt is how readily you can repay them.

As such, both your income and debt-to-income ratio (how much you earn versus how much you pay toward your obligations) will factor into a lender’s decision.

Credit Score

Your credit score is a numerical snapshot of your credit history. The higher your score, the better your chances of being approved at a low interest rate. Usually, lenders who cater to bad credit borrowers charge more interest and fees.

Credit Report

Your credit report is a complete profile of your borrowing and financial activities, including delinquent payments, collections, bankruptcy, and foreclosure.

The more red flags your credit report contains, the less likely you are to be approved at all – let alone with favorable terms.

Alternative Data

Some lenders also look at factors outside your credit report to determine your creditworthiness. Such factors may include your education, occupation, and geographic location.

Applying for a Personal Loan

Applying for a personal loan is fairly easy.

As always, you should start by shopping around different lenders for the best rate and prequalifying for a number of loans. This will give you an idea of what each lender can offer in terms of rate and funding.

Once you find a lender that suits your needs, it’s time to complete your application. Expect to provide data and documents relating to your contact information, Social Security Number, identification, and income. If you’re approved, you’ll receive a loan offer to sign or reject based on the proposed terms.

When you’ve finally signed for a loan, the lender will finalize the paperwork and fund your new loan, sometimes even same day.

Then, you’re off to spend your newfound funds (and possibly set up autopay to start repaying your obligation as soon as possible).

Alternatives to Personal Loans

If you need quick cash but want to avoid high-interest personal loans, you may prefer an outside-the-box option, instead.

#1. 0% APR Credit Card

0% APR credit cards are one of the best ways to take on debt – assuming you can meet the minimum payment – as you don’t have to pay interest.

While few credit cards offer 0% interest indefinitely, many do offer 0% introductory purchase or balance transfer APR for up to 18 months.

#2. Personal Line of Credit

Think of a personal line of credit as the product of a holy union between a credit card and a traditional loan.

To start, you apply for a line of credit just like any other loan. Once the lender approves the application and sets a borrowing limit and interest rate, you can withdraw and repay funds – up to your credit limit – as often as you need.

#3. Borrow Money from Someone You Know

Mixing family and finances isn’t a wise idea for most people – familiarity truly does breed contempt, especially if you don’t repay your debt.

But if you’re responsible, have a good relationship, and – this is important – draw up a contract, then borrowing money from someone you know may be a better alternative to a personal loan.

The downside? You won’t build your credit history in the process.

Bottom Line: What is a Personal Loan?

Personal loans can provide the necessary funding to cover one-time expenses, improve your financial standing, or upgrade your living quarters.

But, as with all loans, they come with their own drawbacks, benefits, and potential and actual costs.

As such, it’s crucial to do your due diligence, shop rates and lenders, and most of all, always read the fine print.

Jordan Blansit
Jordan Blansit

Jordan Blansit is a Senior Writer, Researcher, & Product Analyst for SimpleMoneyLyfe with an inexplicable predilection for mortgages, investing, and personal finance. When she’s not click-clacketing from the comfort of her living room, you can find her in the California Redwoods or Oregon Siskiyous. Jordan’s areas of expertise are mortgages, personal loans, credit cards, and investing.