April 27, 2023
What are personal loans?
A personal loan is a type of unsecured or secured loan that individuals can borrow from banks, credit unions, or online lenders to cover various financial needs, such as consolidating debt, funding home improvements, or covering emergency expenses.
How do personal loans work?
Generally, getting a personal loan entails the following application process to determine eligibility, approval and ultimately funds disbursement:
- Application: The borrower submits an application to the lender, providing personal information, income details, and the purpose of the loan.
- Credit check: The lender generally conducts a credit check to assess the borrower's credit history and determine their creditworthiness. Checking your credit report prior to this general process is a good idea to ensure its accuracy and your scores.
- Loan approval: If the borrower meets the lender's criteria, the lender approves the loan and sets the interest rate and loan terms based on the borrower's credit profile and loan agreement.
- Loan disbursement: Once the loan is approved, the lender disburses the loan amount to the borrower, either as a lump sum or in installments and usually to a bank account, depending on the loan agreement.
- Repayment: The borrower is required to make payments to the lender, including principal and interest, for the duration of the loan term. The loan term and repayment schedule can vary, including the annual percentage rate (APR), and depends on the agreement. Be sure to check if the APR is fixed or variable.
- Early repayment: Some lenders allow borrowers to repay the loan early without any prepayment penalties, while others may charge a fee for early repayment.
What types of personal loans exist?
There are several types of personal loan options available, each designed to cater to different financial needs and borrower profiles. Some common types of personal loans include:
- Unsecured personal loans: These loans do not require collateral and are granted based on the borrower's creditworthiness, income, and ability to repay the loan. Unsecured personal loans can be used for various purposes, such as debt consolidation, home improvements, or medical expenses.
- Secured personal loans: Unlike unsecured loans, secured personal loans require the borrower to provide collateral, such as a car or savings account, to guarantee the loan. Secured loans generally offer lower interest rates and may be easier to qualify for, especially for borrowers with weaker credit profiles.
- Debt consolidation loans: These loans are specifically designed to help borrowers consolidate multiple high-interest debts, such as credit card balances, into a single loan with a lower interest rate and a more manageable monthly payment. Read more about debt consolidation.
- Co-signer personal loans: For borrowers with limited or poor credit history, co-signer loans involve a creditworthy individual (such as a family member or friend) agreeing to share responsibility for the loan. This can improve the borrower's chances of approval and secure better loan terms.
- Fixed-rate personal loans: With a fixed interest rate, the borrower pays the same interest rate throughout the entire loan term. This allows for predictable monthly payments and makes it easier to budget for loan repayment.
- Variable-rate personal loans: These loans have an interest rate that can change over time based on market conditions or a benchmark index. While variable-rate loans may start with lower interest rates, they can fluctuate, making monthly payments less predictable.
- Personal lines of credit: A personal line of credit is a revolving credit line that allows borrowers to access funds as needed, up to a predetermined limit. Borrowers only pay interest on the amount they actually use and can continue to access funds as they repay the borrowed amount.
- Medical loans: These loans are specifically designed to cover medical expenses, such as dental work, surgeries, or fertility treatments. Medical loans may offer more favorable terms or interest rates compared to traditional personal loans.
- Home improvement loans: These loans are intended for funding home renovation or repair projects. Some lenders may offer specialized home improvement loans with lower interest rates or other benefits compared to standard personal loans.
- Wedding loans: Wedding loans are personal loans specifically intended to finance wedding-related expenses, such as venue fees, catering, or photography.
Alternatives to personal loans
- Credit cards: Credit cards can be used for short-term and long-term financing needs and may offer lower interest rates, rewards, or promotional offers. Credit cards can also help you build credit with responsible usage as well as provide on-going access to funds given how they work. There are secured and unsecured credit cards, the former generally requiring some type of collateral like a deposit in order to acquire one while the latter does not require collateral.
- Home equity loans or lines of credit (HELOC): Homeowners can borrow against the equity in their homes through a home equity loan or a line of credit. These loans can offer lower interest rates than personal loans but require the borrower's home as collateral.
- Peer-to-peer (P2P) lending: P2P lending platforms can connect borrowers directly with investors, bypassing traditional banks or credit unions. P2P loans may offer competitive interest rates and flexible loan terms but may have stricter credit requirements.
- Family or friends: Borrowing from family or friends can be a low-cost alternative to personal loans.
- 401(k) loans: Some employer-sponsored retirement plans allow participants to borrow against their retirement savings. This option may offer lower interest rates and longer repayment terms, but it can also have tax implications and may impact the borrower's retirement savings.
- Debt management programs: For individuals struggling with debt, a debt management program offered by a nonprofit credit counseling agency can help consolidate and lower monthly payments, often with reduced interest rates.
- Payday or title loans: These short-term, high-interest loans can be considered a last resort due to their high costs, but have a potential for creating a cycle of debt. Payday loans are short-term loans that require repayment by the borrower's next paycheck, while title loans involve borrowing against a vehicle's title. Keep in mind these types of loans can carry high rates and fees and, unlike credit cards, may not help you build credit. Also, a large company in this space, TitleMax, was recently ordered to pay a $10 million penalty by the CFPB for unlawful title loans and overcharging military families.
When considering a personal loan, it's essential to compare interest rates, fees, and repayment terms among different lenders and evaluate the alternatives to ensure you make the best financial decision for your particular situation.
- Financing a home - CFPB
- Student loans - CFPB
- Payday loans - CFPB
- Fixed vs variable annual percentage rate (APR) - CFPB
- Credit scores - Yendo
- What is a HELOC - Bank of America
- 401ks - IRS
- Secured vs unsecured loan - CNBC