What is a Personal Loan?

If your short-term goals require immediate funds, a personal loan can be a reliable option. Here's what you need to know.

Updated: February 16, 2023

Considering a personal loan? Whether it’s for a costly home improvement, a wedding, or even paying off an auto loan, it may help put your plans into action without requiring you to dip into your savings account. If your short-term goals require immediate funds, a personal loan can be a reliable and manageable option. Here’s what you need to know.

What is a personal loan?

A personal loan is a sum of money offered by a financial institution that can be used for a variety of purposes. It works like this: The borrower is provided with a one-time lump sum of cash, and then the loan is paid back to the lender in monthly payments over a specific time period, also known as a loan term.

The borrower's credit score and credit history determine the annual percentage rate on the loan. Annual percentage rate (APR) is the money that is owed on top of the principal amount of the loan being borrowed. Borrowers with high credit scores will typically have more favorable monthly payments because of lower interest rates. 

A personal loan is different from other types of loans. Personal loans do not require a specific purpose to be utilized. For instance, a mortgage loan and auto loan must be used on a home and a car respectively.

Types of personal loans

There are several types of personal loans. The two most common are unsecured personal loans and secured personal loans.

Unsecured personal loans

A personal loan can be unsecured. This means that the borrower does not have to offer collateral, such as a house or car for loan approval.

Unsecured personal loans typically benefit borrowers with excellent credit. Since the creditworthiness of the borrower determines the interest rate on the loan, individuals with high credit scores will be rewarded with lower rates.

Secured personal loans

Secured personal loans require an individual to offer an asset as collateral on the loan. This option may be beneficial to individuals with lower credit scores who, without collateral, would likely face higher interest rates. The borrower may offer their car (known as a title loan) as collateral for the loan. However, if the loan payments are not made by the borrower, the asset can be seized by the financial institution.

What can a personal loan be used for?

Personal loans are unique because they can be used for almost any purpose. There are several reasons someone may want to take out a personal loan. Some examples include:

  • Debt Consolidation: You may have lingering debt with high interest rates, such as old credit cards. A personal loan could help you pay these off faster while adopting a lower interest rate.

  • Medical bills: A personal loan may give you the lump sum of money needed to wipe out your debt from a medical procedure.

  • Home Improvements: Remodeling your kitchen or replacing your roof can be very expensive. A personal loan can be a great alternative to depleting your savings.

  • Purchasing a car: Most likely, an auto loan will give you a better rate than a personal loan. However, if the personal loan does not require a down payment, this may be more equitable for you.

  • Moving Costs: Moving fees can add up quickly, especially for long-distance relocation. A personal loan will get you money fast to cover these expenses during a stressful time.

  • Refinance existing debt: If you can get a better interest rate from a personal loan, you can use the loan to pay down existing high-interest debt.

There are some situations where a personal loan cannot be used. Several examples include student loans, business expenses, and making a down payment on a house. There are other loan options dedicated to these situations.

How do personal loans work?

A personal loan is an agreed-upon lump sum from a financial institution or online lender distributed to a borrower. During the application process, lenders work with a credit union to check the credit report of the borrower. An annual percentage rate is applied to the principal amount depending on the bureau's credit score findings. The borrower then pays back this loan amount in monthly payments over the agreed-upon loan term.

There are a few steps before the money goes straight into your bank account. Let’s outline them:

  1. Individual submits loan application. At this point, the financial institution pulls a credit report to assess the financial well-being of the applicant.

  2. Bank approves loan. If the lender finds the creditworthiness of the applicant adequate, a loan agreement will be sent to the borrower. At this point the application process is complete.

  3. Interest rate is applied. Whether a fixed interest rate or a variable rate, a percentage will be applied to the principal amount borrowed. Funds should be disbursed to the borrower within a few business days.

  4. Monthly payments are made. Monthly payments consist of the principal plus interest amount. These are paid over a period of time known as the loan term.

  5. Credit score is impacted. Lenders will report to credit bureaus on the timeliness of a borrower's repayment. If monthly payments are met each month, a borrower’s credit score will improve. If they fall delinquent, their score will subsequently suffer. In the case of a secured personal loan, failure to repay the loan within its term can lead to forfeiture of the initial collateral that was leveraged. 

How to pick the best personal loan

All loans are not created equal. There are a few things an applicant should consider when choosing a personal loan: fees, repayment terms, annual percentage rate (APR), borrowing limits, and collateral requirements. Let’s take a closer look at each of these.

Fees

Personal loans may carry other fees depending on the financial institution lending the funds. A few common fees include:

  • Application fee: This is usually a small flat fee ($25-50) due at the beginning of the loan process, when the application is submitted.

  • Origination fee: This fee is leveraged by a lender as a way to reduce risk. It’s usually based on the principal amount borrowed. Typically, these are about 1-6% of the loan amount.

  • Prepayment penalty: These fees are paid by the borrower if they pay off their loan before the end of their loan term. Because the interest rate is based on the length of the loan term, some banks use this as a way to recoup lost funds. This fee is usually around 2% of the original loan amount.

  • Insufficient Funds: Similar to overdrafting your checking account, if there are insufficient funds when collecting a monthly payment, you will incur a fee. This scenario typically carries a $25-50 flat fee.

  • Late payment: Of course, if payments are late or missed you can expect to pay a penalty. These can be a set fee or a percentage of your monthly payment. 

Not all lenders charge fees, however. It is important to understand what fees are associated with each lender prior to applying for your personal loan. Many financial institutions offer “no-fee” lending and help you avoid some of the fees mentioned above. Most, however, still include some fees related to insufficient funds or late payments.

Repayment terms

Repayment terms refer to the amount of time between when money is borrowed and when it is expected to be paid back in full. Repayment terms range from lender to lender. Loans that carry shorter terms typically carry a higher monthly payment. But in the end, with a shorter term, you’ll pay less in interest than if the loan is spread over a longer term.

On the other hand, though longer repayment terms translate to more paid in interest over the life of the loan, they also translate to lower monthly payments. Borrowers must determine what is right for them: a long term and a lower monthly payment vs a short term and less interest paid over the life of the loan.

APR

Annual percentage rate (APR) is the yearly expense which a borrower pays on the loan amount borrowed. APR is calculated by determining how much the loan will cost you every year based on the interest rate and finance charges.

Interest rate and APR are different. Interest rates represent the cost you’ll pay each year to borrow money. APR measures the cost to borrow money, but also takes into account additional fees that may be associated. Since APR includes your interest rate and other fees connected to your loan, your APR will reflect a higher number than your interest rate, and it’s a more accurate reflection of what you’ll pay on top of principal. 

The average personal loan interest rate is around 11%. Individuals with good credit scores will receive lower rates, while those with bad credit can see rates much higher. 

A borrower's APR will differ between financial institutions and online lenders. Factors such as credit score, amount of money borrowed, and length of term also impact APR.

There are ways to lower your APR, such as improving your credit score, choosing a shorter term length, or negotiating with your lender.

Borrowing limits

There is typically a maximum amount of money that someone can borrow from a lender. This is known as the borrowing limit. Several factors can determine an individual’s borrowing limit. A few include credit history, debt-to-income ratio, and loan type.

In order to decide the best borrowing limit for you, you must determine what amount is feasible to pay back within the life of the loan. One thing to consider is your existing debt-to-income ratio. If you already have significant credit card debt or medical bills, can you afford another monthly payment?

Collateral requirements

Typically, personal loans are unsecured. This means that they don't require collateral on the loan being borrowed. Instead, the borrower's credit score, income level, and overall financial well-being are analyzed.

When you’re taking out a secured personal loan, collateral will be required. In this case, a lender will require an asset to offset the risk of the loan, such as savings account funds or a car. Before the borrower accepts the terms of the loan, they must determine if the collateral amount is a reasonable requirement for the loan amount, and if they can stand to lose it should they not be able to repay it in full.

Applying for a personal loan

There are many ways to apply for a personal loan. In recent years, the internet has become the most efficient way to start the research process. You can quickly view terms and conditions from an array of lenders to determine who will work best for you. This is also an easy way to compare multiple loan offers.

There are a few things you can do to prepare yourself for taking out a personal loan. To start, you should have an idea of your credit score. Obviously, the better your credit, the more likely you are to get a good annual percentage rate. You can also use a personal loan calculator to see what your monthly payment will look like based on the loan amount and loan term.

Credit score and debt-to-income ratio are a few ways to know if you are in a good place financially to take on a personal loan.

Personal loan alternatives

There are several alternatives to a personal loan. Depending on your situation, there may be a better option to suit your needs. Let’s take a look at a few.

Credit card

A credit card is a line of credit that is offered by a financial institution to make purchases and is for everyday use. They typically carry a max spend limit based on the creditworthiness of the holder. Repayment for purchases on the credit card are made monthly.

Benefits of a credit card include:

  • immediate access to funds

  • convenience

  • potential to earn rewards

Cons include:

  • high interest rates

  • complex terms

  • annual fees

Personal line of credit

A personal line of credit (PLOC) is similar to a credit card in that an individual receives a spend limit. Payments are then made monthly on what is spent. Unlike a credit card, however, funds can be withdrawn from the PLOC.

A PLOC is also a term loan, meaning it has an expiration date. For instance, a lender may offer you access to funds for a period of two years.

Pros include:

  • quick access to funds

  • no collateral required

Cons include:

  • variable interest rates

  • the risk of over-borrowing past your means, leading to further debt

Home equity loan

A home equity loan is another financial option for homeowners. This allows someone to borrow money based on the equity they have in their home. Equity is determined by the home’s current market value and the balance of the remaining mortgage loan.

Pros include:

  • fixed payments with fixed interest rates

  • access to a lump sum of money

Cons include:

  • leveraging debt against your home, which can lead to foreclosure if loan payments are not met.

Home equity line of credit (HELOC)

A home equity line of credit (HELOC) is similar to a home equity loan. The major difference is that a HELOC is a revolving line of credit instead of a lump sum of money. Borrowers pay based on what they use. 

Pros include:

  • borrowing & paying back only what you need

  • access to a large sum

Cons include:

  • Variable interest rates

  • Using your home as collateral.

How Navient Marketplace can help

A personal loan may be a great option for someone that needs access to funds quickly. They can be used for almost anything, including home renovations, travel, a wedding, or even as a debt consolidation loan. They are a type of installment loan which means they can be paid down monthly based on the loan term.

If you think a personal loan is right for you, Navient is worth considering. We’re an industry leader in loan originations and loan servicing, and we’ve recently partnered with top-tiered financial institutions to build a one-stop shop called Navient Marketplace that can help you choose the option that fits you best.

If you are ready to take the next step in receiving a personal loan, visit Navient Marketplace and start the process today.

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

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