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What Are Personal Loans & Their Uses?

What Are Personal Loans & Their Uses?
Jamie Cattanach

Jamie Cattanach

Updated November 13, 2021
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
A personal loan is a type of loan that you can take out from a bank or lender for a wide variety of purposes. The loan typically isn’t secured by collateral, like auto loans (where the car is collateral) or mortgages (where the house is), which means you can pretty much use the funds at your discretion.While you can use an unsecured personal loan for something frivolous like a vacation, taking out a personal loan still involves going into debt — so it’s best to save them for absolutely necessary expenses, or for money management tactics like debt consolidation.We dive deeper into what a personal loan used is for, what the application process looks like and alternatives to consider.

How Do Personal Loans Work?

Now that we know a little bit more about what personal loans are, let’s talk about how they work. What typically happens is you apply for a personal loan, and if the financial institution approves you, they’ll offer you the money up front in exchange for interest you’ll pay over time (along with paying back the principal, or original loan amount). The interest rate may be fixed, meaning it will always stay the same, or variable, meaning it will fluctuate depending on the market. Fixed-rate loans always have the same monthly payment, while the monthly bill may shift if you’ve taken out a variable-rate loan.Personal loans are paid back in regular monthly payments, or installments, which is why they’re also sometimes known as installment loans. (Other types of loans paid in monthly chunks, including student loans and mortgages, are also installment loans.)

Before You Apply for a Personal Loan: Need-to-Knows

A personal loan can feel like a lifesaver if you’re facing a major expense you couldn’t otherwise pay for — but it’s important to understand that the average personal loan interest rate is relatively high. For instance, at the time of this writing, interest rates for personal loans hover between about 6% and a whopping 30% APR or higher, while mortgage rates sit just over 3% and the average federal student loan is a little more than 4%.Because unsecured loans are inherently riskier to the lender (since there’s nothing to repossess), they tend to come at a higher cost. They can also be more difficult to qualify for, particularly if your credit history needs some work or you’re already in a lot of debt.

Good Things to Get a Personal Loan for

Given their interest rates and the risk of taking out any kind of debt, what are some personal loan benefits that make them worthwhile?Well, for starters, their interest rates are still often lower than credit card interest rates, which average around 16% APR and can go much higher. Additionally, credit cards make it easy to fall into a debt spiral because you can continue to use them until they’re maxed out, with interest compounding and racking up exponentially over time.Additionally, the flexibility of personal loans makes them applicable to a wide range of financial needs. Still, some uses are better than others when it comes to going into debt.Some arguably good reasons to get a personal loan include:
  • Making home renovations or repairs that could increase the value of your property
  • Paying off medical bills or emergency expenses you would otherwise need to put on credit
  • Using a personal loan to consolidate other existing debts, such as credit card debt, which could help you save money in interest over time, pay off your debts more quickly and simplify your repayment strategy
In short, the best uses of a personal loan are ones in which you’ll either save money by avoiding higher interest debt or where you stand to earn back the money you spend on the loan (for instance, in the form of home equity, if renovations paid for with a personal loan increase the value of your property). While it may be tempting to take out a personal loan for a vacation, major event or shopping spree, you’ll end up paying more than you would have if you’d saved up for the expense ahead of time. And if you’re purchasing something you can use as collateral — like a car — you’ll almost always find better interest rates and terms with a secured loan than an unsecured personal loan.

3 Tips for Finding a Good Personal Loan

When shopping for a personal loan, there are a few things to keep in mind to find a competitive offer.

Look for Lower Interest Rates

You’ll obviously want to keep an eye out for options with lower interest rates. As mentioned above, rates for personal loans can range from 6% to well above 30% APR, so it’s worth comparing lenders to see who can offer you the best rate. A percentage point or two might not seem like that much of a difference, but it can certainly add up over the life of the loan.

Don’t Forget to Look at Fees

Interest rates aren’t the only factor to keep in mind — fees are also critical to consider. Some lenders charge steep origination fees or early repayment penalties that could cost you even more in the long run.

Remember Each Lender Has Its Own Policies

Keep in mind, too, that each lender has its own policies as far as the maximum loan amount available, loan terms (the length of time the loan is repaid over) and more. Shopping around can help you find the loan product that’s best suited to your specific needs.

Do Personal Loans Affect Credit?

Like all forms of debt, a personal loan can affect your credit, particularly if you fail to repay it on time and in full each month. Taking out a large personal loan can also have an effect on your credit utilization ratio — though if you’re using the loan to pay off other debts, the overall impact might be positive.Also keep in mind that when you apply for a personal loan, the lender may do a hard inquiry when they pull your credit, which can ding your score by a few points and will remain on your credit report for two years.

Personal Loan Application Process

Applying for personal loans is usually a pretty easy process, especially in today’s digital world. You’ll be asked to provide basic demographic information, such as your name, birth date and address, as well as financial information such as your employment history and income. In some cases, you may be able to obtain pre-approval for personal loans without a hard credit check, but the vast majority of lenders will check your credit score in order to ensure you’re eligible and to determine your interest rate.

3 Tips for Qualifying for a Personal Loan

Wondering how you can increase your odds of qualifying for a personal loan? Here are a few tips.

Improve Your Credit Score Before Applying

Your credit history matters when it comes to qualifying for a personal loan (and getting the best deal once you do), so improving your credit score before applying can be helpful if you have the means to do so.

Make an Effort to Lower Your Debt-to-Income Ratio

Your debt-to-income ratio is another major factor lenders use when qualifying you for a loan, so if you’re able to pay off some existing debts before applying, that could help, too — and may have the additional benefit of also boosting your credit score.

Consider a Cosigner

If you’re having trouble getting your credit score to the point where you can get approved for a loan and qualify for a competitive rate, getting a cosigner could be an option. Their credit score and income could increase the likelihood that a lender will approve you for a loan. Just remember that if you fail to make timely payments, your cosigner will be on the hook.  

Alternatives to Personal Loans

While personal loans can be a great tool in certain situations, it’s always worth looking into alternatives before going into debt — particularly at high interest rates.So if the expense you’re facing is a true emergency and you’re lucky enough to have an emergency fund saved up, it’s worth seeing if you can cover the costs in cash.If that’s not possible, you might look into a 401(k) loan, which draws from your retirement fund, or a salary advance, which involves getting your regular paycheck earlier than you would otherwise. Of course, these options have their own drawbacks and benefits to consider, too, so it’s important to do your research.

The Takeaway

Taking out a personal loan comes at a cost, so it’s a big decision. In some cases,  it might be the right one for your financial needs — particularly if you’re consolidating existing debt.Comparing different personal loans can help you find the right loan for your needs with a reasonable interest rate and affordable monthly payments. Lantern can help — our online tool makes it easy to compare a variety of loan products side-by-side in just a few minutes, and checking your rates won’t affect your credit score.
Photo credit: iStock/PeopleImages
The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC1021246

About the Author

Jamie Cattanach

Jamie Cattanach

Jamie Cattanach is a full-time freelance writer whose work has been featured at CNBC, Yahoo Finance, The Motley Fool, the Huffington Post and other outlets. At SoFi, she writes about investing, retirement, student loans and how to get your money right -- no matter what that means for you.
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