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How Do Personal Loans Work?

How Do Personal Loans Work?
Sarah Li Cain
Sarah Li CainUpdated April 17, 2023
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Whether you’re consolidating debt or looking to fund a large purchase, a personal loan can be an option. Before considering one, it’s crucial to understand how personal loans work and know if you are financially able to handle the debt. Below, we highlight what a personal loan is, how personal loans work, and how one might impact your finances.

What Is a Personal Loan?

A personal loan is a type of secured or unsecured loan where borrowers receive a one-time payment from their lender — either from a credit union, bank, or online lender. The borrower pays back the loan, with interest, in monthly installments for a predetermined amount of time until it’s paid off. Personal loans can be used for a variety of purposes.

How Does a Personal Loan Work?

Many borrowers take out personal loans because of their flexibility — they can be secured or unsecured, and the funds can be used for almost any purpose. Secured personal loans are backed by collateral, whereas an unsecured loan is not.Once you’re approved for a personal loan and complete all loan documents, you’ll receive a lump sum from the lender and repay the loan with monthly payments over a fixed time period — anywhere from a few months to a few years.Personal loan interest rates tend to be more favorable compared to credit card interest rates. Many personal loans are unsecured, like most credit cards, so those who don’t have valuable assets or don’t want to put up any collateral tend to favor these sorts of loans.Now that we’ve gone over how personal loans work, let’s take a look at what you need to consider when shopping around for a personal loan, how to apply for one, and what to do after you’re approved:

1. Finding a Personal Loan

Personal loans are available through credit unions, banks, and online lenders. Before doing your research, think about the reasons you want a personal loan in the first place. Is it to consolidate high-interest debt? Or are you looking to fund a major home renovation? Understanding your reasons will help you find the personal loan that best fits your financial needs.You’ll also want to consider factors such as the amount you want to borrow as well as your desired repayment term. For example, if you want to borrow $50,000 there’s no sense in considering a lender that offers loans only up to $40,000.Checking your credit report is a good first step before applying for any loan. If your credit report includes any errors, disputing those with the credit bureau or company that reported the information may help clean up your credit report. Having an accurate picture of your credit history can be helpful when applying for personal loan offers.

Secured vs Unsecured

Secured personal loansUnsecured personal loans
Require collateralBased on creditworthiness
Lenders typically offer higher loan amountsHigh loan amounts may be based on more stringent requirements like high income and an excellent credit score
Lender may seize collateral if borrower defaultsLenders usually need to take borrower to court to recoup proceeds from defaulted loans
Unsecured personal loans are also called signature loans because you’re using your signature in good faith that you’ll repay the loan back on time. For this reason, lenders tend to approve borrowers with good credit scores and who have a steady and sufficient income source.Secured personal loans are sometimes referred to as collateral loans because borrowers have to pledge collateral to take out the loan. If you default on your loan, the lender has the right to take your collateral to recoup the amount borrowed.

Fixed vs Variable Interest Rates

Fixed-rate personal loansVariable-rate personal loans
Rate stays the sameRate fluctuates over time
Generally higher ratesGenerally lower rates at the start of the loan
The interest rate on a fixed-rate loan remains constant throughout the lifetime of your loan, whereas a variable-rate loan’s interest rate may fluctuate based on the current market rate. Fixed-rate loans may be good options for borrowers who want to know exactly how much they’ll pay each month. Variable-rate loans may be preferred for borrowers who want the initial savings, can afford fluctuating payments, or plan on paying off the loan quickly.

Cosigned Personal Loans

Borrowers who can’t qualify for a loan based on their own credit may be able to apply with a cosigner. This person agrees to be legally responsible for paying back your personal loan in the event you, the borrower, do not. A creditworthy cosigner may signal to lenders that your loan application is less risky.

Debt Consolidation

You can pay off your high-interest debts with a debt consolidation loan, potentially making your debt easier to manage. It’s a financial tool that can be used to save money on interest paid over the life of the loan or keep monthly payments manageable for your budget.

Impact on Your Credit Score

Applying for multiple loans has the potential to harm your credit score. The impact can be minimized, however, if those applications are all submitted within a short span of time. Lenders typically conduct a hard credit pull when assessing a loan application. But credit-scoring models recognize that multiple credit pulls in a short amount of time are likely due to rate shopping for just one loan, so treat them as one single credit pull.

Comparing Lenders

Getting quotes from multiple lenders is a good way to compare what interest rate you might qualify for. Other helpful things to look at during a personal loan comparison are fees charged — origination fee, prepayment penalty, and other possible fees — and how those fees are paid.Some lenders may subtract the fee amounts from the loan proceeds, which will lower the amount of money you ultimately receive. Others may offer to roll them into the loan balance, which will increase the amount of money you must repay.Recommended: 5 Typical Personal Loan Requirements

2. Preapproval

Some lenders offer a personal loan preapproval process during which you can check rates, terms, and loan amounts you may qualify for. This is generally done with a soft credit pull, which does not adversely affect your credit score.*Getting preapproved for a personal loan generally takes just a few minutes of your time with each lender. A preapproval does not guarantee loan approval, but it can help you know what to expect if you apply and get approved for a specific loan product. Applying for a personal loan product may trigger a hard inquiry into your credit report, which can adversely affect your credit score. 

3. The Application Process

After you decide which lender you’d like to use, the application process begins. In addition to providing personal details such as your address and Social Security number, you’ll likely be asked to provide documentation such as your pay stub to show proof of income.Approval times vary by lender, but can be within just hours or a few days. Before signing the loan agreement, it’s important to read and understand the document so you’ll know exactly what your responsibilities are. After you sign the loan agreement, the lender will deposit the loan proceeds into your account within the lender’s specified delivery dates. 

4. What To Do Once You Have a Personal Loan

After the money is in your open bank account, the next step is managing how you spend it. 
  • Is the money to consolidate other debts? Then the next step will be to pay those lenders what they are owed. 
  • Are you planning to use the money for home improvements? Then you might want to start by deciding how much of it can be spent for various parts of the process.
Paying back the personal loan is an important step, too. Setting up automatic payments is a good way to make sure the monthly payments are made on time for your installment loanRecommended: Prepayment Penalty on Personal Loan Explained

Compare Personal Loan Rates Today

There are an abundance of personal loan products offered by credit unions, banks, and online lenders. Whether you’re looking for a secured, unsecured, fixed-rate, or variable-rate loan, you can shop around and compare personal loan rates to get the right offer for you.

The Takeaway

Personal loans can offer a lot of flexibility to help you reach your financial goals, such as consolidating debt or paying for unexpected home repairs. Make sure you’re doing your homework by assessing what personal loan benefits you’re looking for, comparing lenders, and making a plan to pay back your loan on time.Comparing personal loans doesn’t need to take a lot of time when you use Lantern by SoFi. All you need to do is enter your preferred loan details one time, and Lantern populates potential lenders based on what you provided. Best part, it’s at no additional cost to you.Simplify searching for personal loans and find prequalified offers using Lantern.
Photo credit: iStock/sturti

About the Author

Sarah Li Cain

Sarah Li Cain

Sarah Li Cain is a finance writer and podcast producer focusing on topics such as credit, insurance, investing, and real estate. Her work has appeared in major publications such as CNBC Select, Forbes, Redbook, and Business Insider.
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