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What is a personal loan?

Yahoo Personal Finance· Getty Images
Updated 9 min read

A personal loan can give you access to much-needed cash — and can be easy to qualify for, especially if you have a decent credit report and a steady income. You borrow a lump sum of money and make a predetermined number of monthly payments, with interest, until the loan is repaid.

As appealing as personal loans might be, there are some factors to consider.

A personal loan is granted primarily on your creditworthiness rather than being tied to a property, such as a house or a car. The proceeds can be used for just about anything. You might consider a personal loan to cover an unexpected expense, a large purchase, medical bills, home improvements, or to pay off existing high-interest debt.

Because a valuable asset does not back it, the interest rate you pay on a personal loan (averaging 12.35% for a 24-month loan in the fourth quarter of 2023) will likely be higher than on a home mortgage or even a vehicle loan, both of which have been hovering in the 6% to 7% range recently.

However, personal loan interest rates are typically lower than credit card rates, which were slightly over 21% towards the end of 2023.

Let's break down the pros and cons of a personal loan.

Pros:

  • They are often easier to qualify for than a mortgage or car loan.

  • The turnaround time from application to funding can be speedy.

  • You'll likely be able to choose how long your repayment period (called the "term") will be. Generally, installment loan terms for personal use range from one to five years or sometimes a bit longer.

  • You may be able to borrow just a few hundred dollars — up to several thousand.

Cons:

  • You are adding to your debt load. If you struggle to make ends meet, another monthly payment may be the last thing you need.

  • Some personal loans are loaded with fees in addition to the interest costs. These might include origination fees, documentation, various types of optional insurance, and late fees. Be on the lookout for prepayment penalties, too. That's a fee for paying off your loan early.

You can apply for a personal loan from a bank, credit union, online lender, and even some credit card companies.

Any loan offers will be based on the following:

  • A credit check revealing your credit score and payment history

  • Your income

  • Your current debt load and your debt-to-income ratio

These and other factors determine the loan amount a lender may offer, the repayment terms, and the annual percentage rate. As with all loans, the higher your credit score, the lower your interest rate.

With so many lenders looking to get your business, the time frame for getting your loan funded can vary greatly. Online lenders may approve your application in minutes and issue funding almost immediately. Traditional banks may take days, but if you have a relationship with a local bank or credit union, the turnaround time on a loan could be quicker.

Learn more: How long does it take to get a personal loan

With the best personal loans, you might typically expect to receive loan funding in one to seven business days.

Once you receive your lump sum loan proceeds, expect your loan payments to begin within 30 days or so. You'll already know how much your payment will be and how long those payments will continue.

Personal loans come in several variations, including:

A personal loan is often unsecured. That means it doesn't require collateral, such as a mortgage or an auto loan, which are secured by your home or vehicle.

If a lender offers a secured personal loan, you will likely put up a certificate of deposit, a portion of a savings account, stock, or other valuable asset as collateral. Secured loans are easier to qualify for and can have lower interest rates because the lender's risk is lessened by holding something of value in the case of default.

Dig deeper: What is an unsecured personal loan?

Personal loans can have fixed or variable interest rates. A fixed interest rate never changes during the life of the loan. If it's 12% at the beginning, it will be 12% for the complete term of the loan.

A variable interest rate can change. You may begin with a lower rate than with a fixed-rate loan, but that interest charge will be periodically adjusted, just like credit card interest rates are. A variable-rate loan may work to your advantage when interest rates are falling. When rates are rising, not so much.

As with so many financial services these days, you have many options when looking for a personal loan. Of course, traditional banks are on the list, but online lenders can be very convenient and sometimes faster to approve and fund a loan.

It's also good to consider credit unions where you live. They often offer lower interest rates for borrowers with good credit, and you might forge a relationship with a local rep that can be helpful in the future.

Some personal loans are targeted at borrowers with specific needs.

  • Title loans: Vehicle title loans are a common type of secured personal loan, where you use proof of vehicle ownership to back the loan. Unfortunately, they are usually short-term loans with extremely high interest rates and burdensome fees. Plus, if you fail to pay, you can lose your car.

  • Buy now, pay later: There has been a resurgence in popularity for long-in-the-tooth BNPL purchase financing, a spin-off of rent-to-own. While some plans say you'll pay low or even no interest, there can be transaction fees, late charges, and other add-on expenses.

  • Payday loans: These short-term loans require you to issue a personal check or provide checking account draft access to cover any non-payment. The Federal Trade Commission says payday loans typically charge $10 to $30 for every $100 borrowed. That amounts to a nearly 400% interest rate on a two-week loan.

  • Pawn shop loans: Giving a pawn shop personal property for quick cash is another variation of a personal loan. Like title and payday loans, many consumers get trapped in a vicious cycle of "rolling over" the debt with ever-increasing fees.

  • Debt consolidation loans: This type of personal loan is used to pay off high-interest debt such as credit card balances. It's often an attempt to lower monthly payments and save interest, but if you extend the payback period, you can actually add to your total finance charges. Instead, you might seek debt reduction advice from a nonprofit credit counselor.

  • Home renovation loans: Upgrades and repairs can add value to your home. A personal loan can fund those improvements. Another option could be a home equity loan or home equity line of credit.

  • Credit builder loans: Used to establish a credit history and improve your credit score, a credit builder loan is a personal loan in reverse; you begin making payments before receiving the funds. Finally getting the money is almost like a reward for good debt management.

Taking on any debt is a matter of thinking through your current obligations and your future ability to pay. There can be borrower's remorse: Getting the loan proceeds is the fun part. Paying it back can be a burden.

If you've examined your expenses and are confident that a personal loan is a good move, proceed with a plan:

  • Check your credit score before you decide to get a loan. It's likely to be affected once a lender starts processing your application.

  • Shop multiple lenders for the best interest rate and loan terms you can qualify for.

  • Remember to hunt for hidden fees and add-on charges.

  • Be aware that the longer the payback period, the likelier you'll pay more interest.

  • Ask if there will be a prepayment penalty should you decide to pay the loan off early.

Dig deeper: Should I get a personal loan?

A personal loan may be a good solution for you now, but how can you borrow less in the future? That's the key to building wealth over the long term. Having a cash cushion for unexpected expenses and large purchases empowers you to avoid taking on more debt later on.

Start moving money into an emergency savings fund, even if it's just a little at a time. Maximize your returns by considering high-yield savings accounts and certificates of deposit.

Keep one credit card paid off and available for use when a serious need arises.

Consider having a home equity line of credit available, but use it sparingly. The value of your home can be a significant factor affecting your long-term net worth.

Learn more: Home equity loan vs. personal loan

Not usually. Most personal loans are issued based on your ability to repay. That considers your credit history, income, and the amount of debt you already have.

Keep reading: Do you need collateral for a personal loan?

The amount of debt you can carry is a function of your creditworthiness. Lenders look at your debt-to-income ratio to determine if you qualify for any new loans or additional debt.

Dig deeper: How many personal loans can I have at once?

Yes. Some financial institutions offer personal loan programs to borrowers with low credit scores. But be aware of "advance-fee" loan scams. This is when fraudsters guarantee they can provide you loans or credit cards "no matter your credit score" but require payment upfront. After collecting the fees, they disappear.

Learn more: How to get a personal loan with bad credit?

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