In a Nutshell
Personal loans can be a good option if you need cash for a specific purpose. But there are many factors to consider when determining the type of loan that’s right for you.Every year, millions of Americans use personal loans to consolidate debt, pay for unexpected expenses, make home improvements and more.
Why are personal loans appealing to so many? Personal loans offer low interest rates for consumers with good credit, and they’re generally smaller loan amounts than other types of loans. But they aren’t necessarily the best solution for everyone.
If you’re thinking about getting a personal loan, here are six things you should know about personal loans before you make your decision.
- How do personal loans work?
- Types of personal loans
- Applying for a personal loan
- Personal loans vs. other lending options
- Impact on your credit scores
- Interest rates and other fees
1. How do personal loans work?
Personal loans are a type of installment loan. That means you borrow a fixed amount of money and pay it back with interest in monthly payments over the life of the loan — which typically ranges from 12 to 84 months. Once you’ve paid your loan in full, your account is closed. If you need more money, you have to apply for a new loan.
For budget-conscious borrowers, personal loans can be more manageable than other forms of credit because they can have fixed interest rates, fixed terms and fixed payments.
- Fixed interest rates. The interest rate that is set when the loan is granted is the interest rate for the life of the loan. Rates vary from lender to lender and from borrower to borrower. Rates currently range anywhere from an APR, or annual percentage rate, of around 5% or 6% on the low end to nearly 36% on the high end.
- Fixed terms. The set period of time the borrower has to pay off the loan can vary, but in many cases it runs three to five years. The loan term is usually described in months.
- Fixed payments. With an interest rate and other loan terms that are fixed, the monthly payments are also fixed. This means payments will not fluctuate, therefore lowering the chances of any surprise increase.
2. Types of personal loans
There are two types of personal loans — secured and unsecured. It’s important to think about why you need the money and then choose the type of loan that’s most appropriate based on your current financial situation.
- Unsecured personal loans aren’t backed by collateral. The lender decides whether you qualify based on your financial history. If you don’t qualify for an unsecured loan or want a lower interest rate, some lenders also offer secured loans.
- Secured personal loans are backed by collateral, such as a savings account or CD. If you’re unable to make your payments, your lender typically has the right to claim your asset as payment for the loan.
3. Applying for a personal loan
Banks are probably one of the first places that come to mind when you think of where to get a loan. But they’re not the only type of financial institution that offers personal loans. Credit unions, consumer finance companies, online lenders and peer-to-peer lenders also offer loans to people who qualify.
Much like any financial decision, your choice of lender and loan amount should not be made on a whim. When applying for a personal loan, shop around — rates and terms will vary. Pay attention to these tips when comparing lenders for the personal loan that best fits your situation.
- Have all your required documents handy. When applying for a loan, the following information may be required: personal contact information; date of birth; Social Security number; employment and income information, including recent paystubs or W-2 tax forms; and loan amount needed.
- Know your borrowing needs. You know your financial responsibilities and budget better than anyone. Have a game plan before applying for a loan, and know exactly how much you need and how long you will realistically need to repay it. Personal loans can range from $2,000 to $50,000 — or even up to $100,000.
- Make sure your credit is in good shape. A borrower’s credit risk is determined by a number of factors. Lenders can consider your current credit scores, credit reports, income, debt-to-income ratio and overall financial situation.
- Take note of any fees or penalties. Normally, personal loans come with certain fees, like origination fees and prepayment penalty fees. The origination fee, charged by the lender to process the application and disburse the funds, is usually a percentage of the loan amount or a flat rate set by a specific lender. Prepayment penalties occur when the borrower wants to pay off the loan before the set terms of the loan. Since these fees are not charged by all lenders and vary in cost, be sure to ask upfront about any fees or penalties tied to the loan.
4. Personal loans vs. other lending options
While personal loans can provide the cash you need for a variety of situations, they may not be your best choice. If you have good credit, you may qualify for a balance transfer credit card with a 0% introductory APR. If you can pay off the balance before the interest rate goes up, a credit card may be a better option.
Be aware: If you get a balance transfer card and can’t pay off your balance or make a late payment before the introductory rate expires, you may rack up hundreds or thousands of dollars in interest charges.
If you’re a homeowner, you might consider a home equity loan or line of credit, sometimes called HELs or HELOCs, respectively. These type of loans could provide the financing you need for larger loan amounts at low rates. While HELs are generally installment loans, HELOCs are a type of revolving credit. But beware: Your house becomes the collateral for these types of accounts. If you default, your lender usually has the right to foreclose on your home as payment for the loan.
5. Impact on your credit scores
When you apply for a loan, the lender will pull your credit as part of the application process. This is known as a hard inquiry and will usually lower your credit scores by a few points.
Generally speaking, hard inquiries stay on your credit reports for about two years.
When you’re shopping around for the best rates, some lenders that you already have an account with will review your credit. This is known as a soft inquiry and doesn’t affect your credit scores.
Consider checking your rates with lenders that will do soft pulls, which won’t impact your scores.
6. Interest rates and other fees
Interest rates and fees can make a big difference in how much you pay over the life of a loan, and they vary widely from lender to lender. Here are some things to consider.
- Interest rates: Rates typically range from around 5% to 36%, depending on the lender and your credit. In general, the better your credit, the lower your interest rate will be. And the longer your loan term, the more interest you’re likely to pay.
- Origination fees: Some lenders charge a fee to cover the cost of processing the loan. Origination fees typically range from 1% to 6% of the loan amount.
- Prepayment penalties: Some lenders charge a fee if you pay off your loan early because early repayment means that the lenders are missing out on some of the interest that they would have otherwise earned.
Before signing on the dotted line, consider adding up all the costs associated with the loan, not just the interest rate, to determine the total amount of money you’ll be responsible for repaying.
Next steps
A personal loan is an option to explore when you need money to cover a certain expense. Borrowing money, no matter the amount, is an obligation that can work to your benefit if treated responsibly — or it can put you in serious financial trouble should you not repay the loan according to the loan’s terms. Before deciding to sign your name on that dotted line for approval, make sure this is the right financial choice for you.
As a next step, check out our take on some of the best personal loans for various needs and continue exploring your options.
*Approval Odds are not a guarantee of approval. Credit Karma determines Approval Odds by comparing your credit profile to other Credit Karma members who were approved for the personal loan, or whether you meet certain criteria determined by the lender. Of course, there’s no such thing as a sure thing, but knowing your Approval Odds may help you narrow down your choices. For example, you may not be approved because you don’t meet the lender’s “ability to pay standard” after they verify your income and employment; or, you already have the maximum number of accounts with that specific lender.