Personal loans are a versatile source of funding that can be used for almost anything. They’re a popular solution for everything from funding big home improvement projects to covering unexpected expenses. They’re also popular to use as a debt consolidation loan, which can help you lower your interest rates and get out of debt faster.
Any time you take out a loan, it’s important to research your options and determine whether or not it’s the right fit for your financial situation. In this article, we’ll discuss everything you need to know about personal loans, including how personal loans work, where you can get one, and what alternatives to consider.
What to know about personal loans: key takeaways
A personal loan is a lump sum of money that can be used for almost any purpose.
Individuals with high credit scores and low existing debt will likely get the best rates.
Borrowers can use personal loans to consolidate their existing credit card debt into one monthly loan payment.
Banks, credit unions, and online lenders are a few of the most popular sources of personal loans.
Personal loans are suited for debt consolidation, critical expenses, and purchases that will help you build equity. They’re not recommended for everyday or non-essential expenditures.
What are personal loans and how do they work?
A personal loan is a type of installment loan that can be used for a wide variety of purposes. The money is handed over in a lump sum, leaving the borrower to do almost anything they want with it. Some of the most popular uses for personal loans include debt consolidation, home repairs, and medical expenses. However, loan proceeds may not be used for postsecondary educational expenses, including refinancing federal or private student loans.
So, how exactly do personal loans work?
First, the borrower submits a loan application to a lender, like a bank or credit union. The lender then checks the borrower’s credit score, debt history, and other markers of creditworthiness. If the borrower passes the credit check, the lender will then hand over a set amount of money, which must be paid back over a fixed period of time with interest.
The interest rates on personal loans are often lower than you’d find on other types of short-term debt, like credit cards or payday loans. That said, personal loan interest rates do vary depending on the type of loan and the creditworthiness of the borrower.
The different types of personal loans available
There are a few different types of personal loans available, each with its own benefits and drawbacks. Let’s take a look at the three most common types of personal loans: secured, unsecured, and peer-to-peer.
Secured personal loans are backed by collateral, such as a home or car. If the borrower defaults on the loan, the lender can seize the collateral to recover their money. This gives the lender an extra level of reassurance that they’ll be able to recoup their investment. For that reason, secured personal loans tend to have lower interest rates than unsecured personal loans.
Unsecured personal loans do not require any collateral. So, if the borrower defaults, the lender has no way to recoup their money except through legal action. For that reason, lenders face more risk with unsecured loans, which is why these types of loans usually come with higher interest rates. They are typically given to borrowers with good credit scores.
Peer-to-peer (P2P) lending describes a newer type of loan setup that connects borrowers and lenders directly without using a bank or credit union as an intermediary. This type of loan typically comes with lower interest rates than other types of personal loans since there’s no middleman.
The benefits of personal loans
There are a number of benefits to taking out a personal loan. Here are a few of their best qualities:
Flexible
Personal loans offer borrowers more flexibility than other types of loans. This is because personal loans can be used for almost any purpose, whereas other types of loans are typically tied to something specific, such as purchasing a car or a home. Need to use part of the loan to pay off some debt, and the rest to finance a home repair? With a personal loan, that’s no problem
Disbursed in one lump sum
Most personal loans are disbursed in a lump sum. This means you receive the entire amount of the loan at once, rather than receiving it in installments. When you have the money all at once, you’re free to use the whole loan immediately (to pay off a high-interest credit card in its entirety, for example), and it’s easier to stay organized since everyone involved knows exactly how much money needs to be paid back and when.
Good for refinancing high-interest debt
Personal loans are a good option for refinancing high-interest debt. When you have multiple debts with different interest rates, it can be difficult to keep track of what you’re paying and how much interest you’re accumulating. A personal loan lets you effectively transfer all those debts to a single new loan. You’re left with a single bill and a single fixed interest rate to keep track of. In addition, personal loans usually have lower interest rates than credit cards. Refinancing your debt in this way can therefore save you money over the life of the loan by drastically reducing your total interest charges.
Lower Risk
Unsecured personal loans are less risky for borrowers than many other types of loans. Take secured home equity loans, for example. If you want to take out a loan to consolidate your high-interest debt but don’t have much equity in your home yet, you could take out a personal loan instead. This would give you the funds you need without putting your home at risk.
How to get a personal loan
There are a number of ways to get a personal loan, but the most common way is through a bank, online lender, or a credit union (a non-profit, community-based financial institution). Here’s what the process looks like:
1. Look for banks or credit unions that offer personal loans
If you’ve decided a personal loan is for you, there are a few different places you can start your search. Which is best for you will depend on your situation.
A bank where you already have an account
A great place to look for a personal loan is at an institution where you already have a bank account. This existing relationship may help you down the line when lenders want to know more about your financial history. Big banks tend to offer lower annual percentage rates (APRs) and higher loan amounts to individuals in good standing with them, but are less likely to offer a loan to someone with bad credit.
A credit union if your credit score isn’t exceptional
Credit unions tend to be more favorable for those with low to average credit. Credit union loan officers may be willing to consider other factors beyond your credit score to help you get a loan. Because credit unions are usually local or regional, you can expect more personal service throughout the process as well. The only catch is that to apply for a loan through a credit union, you must be a member, which usually requires a small fee.
An online lender if you’re looking for speed and convenience
Another option is using an online lender. Online lenders allow you to quickly shop around and review multiple loan offers from the comfort of your home. Because you can compare so many options at once, it’s easier to figure out if you are getting a good rate.
A potential downside to having an online lender is that you will need to use email, phone, or online chat to resolve any issues. With a bank or credit union, you can address questions by walking in and getting more personal service, which some borrowers prefer.
2. Compare interest rates between different financial institutions
Each financial institution will likely offer you a different interest rate. Make sure to compare rates before you decide which one to go with.
Each offer will be based on factors like your credit score, debt-to-income ratio, and credit history. Lenders will review this information by pulling your credit report. According to Experian, one of the “Big Three” credit bureaus, a “good” credit score is anything above 700, and an “excellent” score is 800 or more. The amount and term length of the loan will also affect the rates your lender can offer you. If you are in good financial standing and can commit to a shorter loan term, you will likely receive the best rates a lender can offer.
While different borrowers will qualify for different interest rates, a “good interest rate” is typically defined as one that falls below the national average. In August 2022, the national average interest rate for a personal loan was about 10%.
3. Apply for a personal loan with the lender of your choice
When you’ve decided on a lender, your next step is to fill out a loan application. During the application process, you will need to provide proof of identity, such as a driver’s license or passport, as well as your social security number. The lender will also want to verify your employer and income, so they may request a pay stub or W2 form, as well. Rental agreements or mortgage statements may be required to provide proof of address.
4. Wait for approval from your financial institution
Once you submit your application, your lender will review it and let you know if you’ve been approved for a loan. Approval for a personal loan can take one to seven days. This can sometimes take longer if there’s a delay with your credit check or a backup at your bank or credit union. Applications tend to be approved more quickly with online lenders than with brick-and-mortar institutions.
5. Sign the agreement and receive your funds
If you’re approved for a loan, the lender will send you a document outlining the terms of the loan agreement. Be sure to carefully read the fine print, as this document will include everything you’re about to commit to, including the total amount of the loan, the repayment terms, the loan APR, and the monthly installment amounts and deadlines. After you sign this agreement, the funds will be disbursed to you. At that point, you cannot change your mind and go back on the agreement.
6. Continue repaying the loan until your debts are paid off
It’s important to make your loan payments on time. Lapses in payment will likely result in late fees. Failure to repay the loan will also carry serious penalties. You could be subject to more fees, damage to your credit score, collections calls, or even legal ramifications.
Things to consider before taking out a personal loan
There are a number of things you need to consider before taking out a personal loan. Here are a few of the most important.
How much do you need?
Personal loans typically range from $1,000 to $50,000. That’s a big range, which means you’ll need to decide how much money you need before you apply. Do some calculations to figure out how much you’ll need to cover your expected home repair, pay off your credit card debt, or achieve another financial goal. Then, take out only what you need. This will ensure you won’t incur unnecessary interest charges, and it will keep your monthly payments within reason.
What is the repayment schedule?
Most personal loans have a repayment schedule, or loan term, of either three or five years1. Because personal loans are a type of installment loan, you will make monthly payments based on the amount you borrowed plus interest. These payments will continue until the loan is paid back in full. Before you sign off on a loan, make sure you can afford the monthly payments and that the repayment schedule aligns with your other financial goals.
What are the fees?
Many personal loan servicers charge origination fees, late-payment fees, or prepayment penalties. Origination fees are associated with the administration and processing costs of the loan and are typically a small percentage of the overall loan amount. Late fees are incurred if you fall behind on payments. A late fee can be a set amount or a percentage of your monthly payments, depending on your loan servicer.
Not all loan servicers charge prepayment penalties. However, some do charge a fee if you pay off the loan prior to the end of the term. Because lenders make money on interest charges, this is their way of locking you into the total cost of the loan. If you expect to pay off your loan quickly, either select a servicer that doesn’t charge prepayment penalties, or choose a loan with a shorter term.
Are there better payment options for your situation?
Personal loans might not be the best choice if low-interest, purpose-made loans exist for your situation. Medical bills can often be resolved with your healthcare provider at a low cost to you. Auto loans and mortgage loans are often better options for car and home purchases, and student loans give borrowers much more flexibility and protection, making them a better option than personal loans for paying college tuition and fees.
A home equity line of credit (HELOC) could suit your needs if you are looking to do home renovations. (That said, a HELOC is a type of secured loan, which means it could put your home at risk if you fail to pay it off on time.)
If your credit history is weak and you are looking to build credit, a credit card may be a better option for you. You can read more about alternatives to personal loans below.
Alternatives to personal loans
Personal loans aren’t the best option for every situation. Here are some alternatives to consider.
Cash-out refinance
A cash-out refinance is when you replace your current home loan with a new (higher) mortgage for the existing value of the home, and receive the difference in funds for the equity you’ve built. You can use the extra cash to pay off high-interest debt, make home improvements, or cover unexpected expenses.
A cash-out refinance can be a great way to get a lower interest rate on your mortgage and free up some extra cash at the same time. It's important to remember, however, that you will be paying off the new loan over a longer period of time. So make sure you're comfortable with the monthly payments (and total interest charges) before you apply.
Home equity loan
A home equity loan is a type of secured loan in which the borrower uses their home as collateral. It is a lump sum of cash that you receive all at once. You must repay the entire loan amount plus interest over a fixed period of time, usually 5 to 10 years.
This type of loan is usually used to finance major expenses such as tuition, medical bills, or home improvements. Home equity loans are available in both fixed-rate and variable-rate formats, and typically have lower interest rates than unsecured loans, including most personal loans.
The amount you can borrow with a home equity loan depends on the value of the property you plan to use as collateral. (It will also depend on your credit score.) In most cases, homeowners can borrow up to 80% of the property's value.
The biggest downside to home equity loans is that they put your house at risk. If you default on a home equity loan, you could lose your home.
Home equity line of credit (HELOC)
Unlike a home equity loan, which is a lump-sum loan, a home equity line of credit (HELOC), is a pool of funds that you can take out and pay back on a revolving basis. With a HELOC, you can borrow as much or as little as you need up to your approved limit, and you only pay interest on the amount you actually borrow.
HELOCs are popular because they offer more flexibility than traditional term loans. You can borrow what you need when you need it, and there are no prepayment penalties if you want to pay off the debt early. However, since interest rates for HELOCs are always variable, they can go up over time according to national trends. If rates go up, you could be stuck paying more money than you originally expected.
Payday loans
A payday loan is a short-term, high-interest loan, typically due around the time you receive your next paycheck. These loans are also sometimes referred to as cash advances.
Payday loans are often characterized by very high interest rates — sometimes up to 400% — and they are particularly harmful to borrowers who cannot afford to repay them on time. Payday loans are generally only useful to people who need a small amount of cash quickly and cannot qualify for other, more forgiving loan options because of poor credit history. For that reason, they’re typically considered a last resort.
Find the best personal loans with Navient Marketplace
Personal loans are a versatile line of funding that can be used for almost anything. While they are not right for everyone, they can be great for borrowers that have good credit and are looking to fund a large purchase or consolidate debt.
If you've decided a personal loan is right for you, your next step is to start shopping for competitive loan offers to make sure you get the best rates. One of the best ways to do this is through the Navient Marketplace. This is a unique, comprehensive database of available lenders and loan options. It’s a great tool to find out what’s out there, compare loan offers, and find the solution that best fits your financial goals. Check out the Marketplace today to compare rates and find a personal loan that suits your needs.