How Do Personal Loans Work?

Before you apply for a personal loan, it's important to understand how they work. This guide explains all you need to know.

Updated: February 16, 2023

Personal loans are one of the most popular types of loans, and there's a good reason why. They can be used for a variety of purposes, from consolidating debt to financing home-improvement projects. And because there are so many lenders out there, it's easy to find one that fits your needs.

But before you apply for a personal loan, it's important to understand how they work. In this blog post, we'll break down everything you need to know about personal loans including how they're different from other types of loans, the factors that determine your interest rate, and how to choose the right lender. 

How does a personal loan work? Key takeaways:

  • A personal loan is a lump sum of cash that can be used to finance almost any large expense.

  • Lower interest rates are usually offered to borrowers with low debt and high credit scores.

  • You can use a personal loan to consolidate your existing high-interest debt into a single new loan with a single monthly payment.

  • Home improvements that add value to your house are a great way to utilize personal loans.

  • Personal loans are not likely the smartest option when it comes to daily purchases. 

What is a personal loan?

So, what exactly is a personal loan? In short, it's a type of loan that can be used for just about anything — from paying off credit cards to covering unexpected medical bills. Unlike car loans or mortgages, there aren't many restrictions on how you can use a personal loan. However, loan proceeds may not be used for postsecondary educational expenses, including refinancing federal or private student loans.

There are two types of personal loans: secured and unsecured. Most personal loans are unsecured, meaning the lender doesn’t require you to offer collateral like a home or car to back them up. These are considered less risky than secured loans, which do require collateral. However, interest rates on unsecured personal loans may be higher than rates on secured loans.

When taking out a personal loan, it's important to consider the terms, rates, and payment schedule carefully to make sure you can comfortably afford the monthly payments. In the long run, a personal loan can be a useful tool for achieving your financial goals — as long as you’re not taking on more debt than you can handle.

How do personal loans work?

Once you decide to move forward with a personal loan, you’ll complete a loan application from a financial institution. The lender will then pull your credit report to determine your creditworthiness.

If you have good credit history, the lender will offer you a low annual percentage rate (APR). If you have bad credit, you may still receive a loan approval but for a higher interest rate. Other factors, such as the amount of money you borrow and the loan term (the time it will take you to pay off the loan) will impact your APR, as well.

If you like the offer you receive, you’ll sign the loan agreement, and the lender will disburse the lump sum of cash, usually straight to your bank account. You’ll then pay it back in monthly installments until the loan term is up. (For this reason, personal loans are considered a type of “installment loan.”) If you miss a payment or make a late payment, you’ll have to pay a penalty. If you fail to pay back the loan, it could go to collections.

That’s the brief overview of how personal loans work. Here’s how the whole process works in detail:

Step 1: Determine whether or not you need the loan

While you can use a personal loan for just about anything, that doesn’t mean you should. For example, a lavish vacation adds little value to your long-term financial situation, and a personal loan will only compound that risk. It’s also not recommended to use a personal loan for weddings, parties, or large purchases. These are all hard to justify going into debt for.

Of course, big unexpected expenses like home repairs can sometimes leave you with limited options. You can either put off the renovation until you’ve saved up enough cash, or use a financing option such as a personal loan to cover it. A personal loan is easier to justify if the home repair or renovation absolutely cannot wait, will definitely add value to your home, and can’t be covered by insurance. In this case, a personal loan can give you the cash you need right away.

Debt consolidation is another popular reason to take out a personal loan. If you have high credit card debt or multiple lines of credit, you can use a personal loan to consolidate your payments into a single new loan with a new interest rate. The benefit here is that you can work with one institution to pay off your overall debt rather than having to juggle multiple lenders and bills. You may also be able to save money in interest charges by converting your high-interest-rate debt into a lower-interest-rate personal loan.

A good general guideline is that if the expense is not urgent or necessary to your wellbeing, it may be wise to wait until you have the cash in your savings account to fund that expenditure. If it is urgent and necessary, a personal loan could be a great solution.

Step 2: Assess your financial situation

When considering a personal loan, make sure that taking on additional debt will not put you in a worse position than you’re currently in. You can do this by looking at your monthly budget and making sure you have enough extra income to cover the monthly payment on your personal loan. You should also pull your credit report to get an idea of what kind of rates you’ll qualify for.

Find your credit score

Lenders typically require a minimum credit score of 560 to 660 before they’ll agree to lend to you. If you have a credit score above 700, you’ll qualify for even lower interest rates, which will allow you to save a considerable amount of money over the life of the loan.

Determine your DTI

Lenders also consider other factors, like your debt-to-income (DTI) ratio. Your DTI is your total monthly debt divided by your gross monthly income. Because individuals with higher DTI ratios tend to have more trouble making payments, lenders view those borrowers as riskier. For that reason, they offer those borrowers higher interest rates.

Look at your credit history

The length of your credit history is important, as well. If a lender can see that you are consistently making on-time payments on your other forms of debt, they may be more likely to offer you a lower rate. Lenders also favor borrowers with high income and/or few other debt obligations. If your current financial situation is less than ideal, it may be wise to wait until it improves before applying for a personal loan.

Step 3: Shop lenders

If you’ve determined that a personal loan is right for you, it’s time to research your options. Every lender offers different rates, terms, fees, and perks, so it’s worth shopping around. If possible, try to only get rate estimates from lenders who advertise “free rate checks,” or “soft credit pulls,” especially if you’re early in the research process. These kinds of credit checks won’t show up on your credit report.

“Hard credit checks,” however, will show up on your report. These types of credit pulls are unavoidable in the final application phase, but are worth keeping track of. If a lender sees multiple hard credit pulls on your report, they might view you as a riskier borrower. Credit bureaus typically react the same way, dropping your credit score by several points per hard credit check.

There is one exception to this rule. If you make multiple hard credit pulls within a certain time period, typically 45 days, those pulls will all get lumped together and will show up on your credit report as a single inquiry. This is called the “rate shopping exception” and is designed to protect borrowers who are just trying to do their due diligence. So it’s best to try and complete all your rate shopping within this 45-day window.

Step 4: Evaluate your offers

Once you find a lender you like, you’ll fill out a personal loan application, which usually includes things like your social security number, pay stubs, and other financial documents. Once you submit your applications, each lender will make you an offer. Here are a few things to consider when reviewing your loan offers:

Interest rate

Your personal loan interest rate, or APR, will determine how much money you’ll pay in addition to the principal (the total amount of money you borrowed). The higher the loan APR, the more you’ll pay over the life of the loan.

Type of interest rate

There are two types of interest rates: fixed rates and variable rates. Fixed interest rates lock you into a single rate for the entire life of the loan. Variable interest rates, however, fluctuate according to a national benchmark called a “rate index.” When national interest rates go up, so will the rate index—and therefore so will the monthly payment on your variable-rate loan. Variable rates can be beneficial if interest rates are high now but might fall in the future.

Repayment term

Your loan term, or repayment period, will also impact your monthly payment amount. Personal loan terms are typically 12 to 60 months1. The longer your loan term, the lower and more affordable your monthly payments will be. However, paying interest for a longer period of time means your loan will cost you more in the long run.

Origination fees

Most lenders charge upfront costs during the application process to cover administrative expenses. Sometimes the origination fee is a small flat rate. Other times, it’s a percentage based on the amount of money borrowed. If you’re borrowing a large sum, your fees could be substantial. Before you take out a loan, make sure you understand how the lender plans to charge for origination.

Other fees

Some banks, credit unions, or other financial institutions may charge additional fees. Late fees, prepayment penalties, and other processing fees could ultimately affect the loan’s affordability.

Monthly payments

Once you know your principal, interest rate, repayment term, and fees, you will be able to calculate your monthly payment. (Most loan agreements will state this amount, but you can calculate it ahead of time using a personal loan calculator.) Your monthly payment is the cost that the lender will expect you to pay each month for the duration of the loan term. Before you sign the loan contract, make sure the monthly payment is an amount you can easily afford.   

Payment structure isn’t the only factor that can affect your choice of loan provider. Take time to read only reviews and do some research. Make sure the lender is trustworthy and reputable and has a track record of good customer service.

Step 5: Sign on the dotted line and receive your lump sum

Once you select a lender, it's time to sign the agreement and receive your funds in as little as a day. Some lenders will give you a grace period during which you can change your mind. This is usually the space of time after you’ve signed the agreement and before you’ve received your funds. For some lenders, this period is less than a day. For others, it’s up to a week. Once you receive your loan amount, you are committed to the loan.

Step 6: Make on-time payments

The final step is to pay back the loan. If you planned properly, your loan payments should fit into your monthly budget, and you should have no problem making them on time.

Keep in mind that missing a payment will result in a penalty, but isn’t the end of the world. Missing multiple payments, however, can have serious negative consequences. If you fail to repay a secured personal loan, the lender could seize the asset you offered up as collateral. If you fail to pay back an unsecured personal loan, you’ll face other repercussions, like damage to your credit score, fees, collections calls, and even lawsuits from your creditors.

Pros and cons of personal loans

There are positives and negatives associated with most financial decisions. It is important to understand both to determine if a personal loan is right for you. 

Here are some of the pros of taking out a personal loan:

  • One lump sum: The funds are delivered all at once and can be used immediately. This makes personal loans convenient for large purchases

  • Quick approval process: You can get approved for a personal loan in as little as a day.

  • Lower interest rates than credit cards: Personal loans generally carry low interest rates relative to most credit cards. While credit cards may offer generous introductory terms, their rates can become very high once those introductory periods expire.

  • Simpler payments: You can use a personal loan as a debt consolidation loan to pay off credit cards and other short-term loans. This is essentially a DIY refinance of your high-interest debt. After you refinance, you’ll be left with a single loan with a simple monthly payment.

  • Lower monthly payments: Compared to other short-term loans, personal loans tend to have the best rates, longest loan terms, and lowest monthly payments.

Some of the cons of personal loans include:

  • Additional debt: If you’re not financially stable, taking on more debt could leave you in a worse situation.

  • Hard on borrowers with bad credit: If your credit is not up to par, you could receive unfavorable rates — or fail to qualify for a personal loan at all.

  • Potentially high fees: Origination and processing fees can add up. Make sure your monthly payments are affordable.

  • You could need collateral: Depending on your creditworthiness, you may be obligated to offer collateral, such as a car or savings account, to secure the loan. This puts some of your biggest personal investments at risk.

  • Not for every scenario: If taking out a personal loan won’t help you gain equity, it’s usually better to put off the expense until you’ve saved up more cash.

Where can I get a personal loan?

Many different financial institutions offer personal loans. Here are a few of the most popular:

  • Online lenders: These allow you to shop and compare interest rates without having to leave your home. A potential downside is that you’re less likely to have a pre-existing relationship with an online lender, so they might offer higher rates than banks or credit unions, depending on your credit history.

  • Credit unions: Credit unions are a better option for borrowers with poor credit because they tend to have softer eligibility requirements and lower rates. You must be a member of the credit union, which can require a small fee. They also generally require in-person appointments to take out a loan.

  • Banks: If you already have a relationship with a bank, they might be the easiest lender for you to work with, and your financial history together could help you secure a lower rate than you would get with an online lender. Sometimes banks will require you to apply for the loan in person, which can be inconvenient. Banks often charge higher interest rates than credit unions do.

Personal loan alternatives

if you’ve determined that a personal loan isn’t right for your situation, consider one of these alternatives:

  • Credit cards: A credit card is a line of funds issued to a user for purchasing everyday goods and services. Credit cards tend to have high interest rates if you don’t make the monthly payments on time.

  • Cash-out refinance: If you take out a new mortgage loan that’s more than what you currently owe, you can receive the difference in cash.

  • Home equity loan: A home equity loan or home equity line of credit (HELOC) is a type of secured loan that’s backed by the equity in your home. Home equity loans sometimes have lower interest rates than personal loans. However, they can result in the foreclosure of your home if you don’t pay them back according to the terms.

  • Payday loan: Payday loans are small, short-term loans given as an advance on an individual's income. You’re supposed to pay them back as soon as your next paycheck comes in. If you don’t you could be subject to extremely high interest rates — anywhere from 20% to 400% of the principal.

Find the best personal loans with Navient Marketplace

Personal loans are one of the most versatile types of loans out there. Unlike student loans or auto loans, they are relatively easy to obtain and can be used for almost anything. If you have a solid credit history and can afford to take on the monthly payments, you could be a perfect candidate for a personal loan.

When considering lenders and your loan options, check out the Marketplace by Navient. They have partnered with top financial institutions and bundled numerous options for you to review, all in one place.

Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.

1 Representative Example: If you borrow $5,000 on a 36 month repayment term and at a 10% APR, the monthly repayment will be $161.34. Total repayment will be $5,808.24. Total interest paid will be $808.24

Get matched with a personal loan offer in 60 seconds or less.

Get Connected

Stay up to date on the latest offers in the Marketplace by Navient!

By submitting this form, you agree to receive emails from Navient and its subsidiaries.