What Is a Personal Loan? How Do Personal Loans Work?

By Janet Schaaf · December 15, 2021 · 10 minute read

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 What Is a Personal Loan? How Do Personal Loans Work?

A personal loan is borrowed money from a bank, credit union, or online lender that is paid back with interest in installments and offers flexible ways to be used. Personal loans work a little differently than other types of loans. Most loans specify what the money should be spent on: Mortgages are used to purchase or refinance homes, and student loans are used to pay for an education. But there aren’t as many restrictions on how you can or can’t spend personal loan funds, which allows for more flexibility than other types of loans.

Most banks, credit unions, or online lenders like SoFi offer personal loans. Read on to learn more about how personal loans work, different uses for personal loans — and simply what a personal loan is.

How Does a Personal Loan Work?

Personal loans are fairly straightforward. They are simply a borrowed sum of money that the borrower then pays back, with interest, to the lender.

How Do You Get the Money?

The first step is applying for a personal loan, which will be detailed below. After loan approval, the lender typically deposits the loan proceeds directly into the borrower’s bank account.

How Do You Pay It Back?

Personal loans are paid back in monthly installments of principal and interest. Since personal loans generally have fixed interest rates, each monthly payment is the same throughout the term of the loan.

How Interest Rates Work

The interest rate a loan applicant may be approved for will usually be determined by a combination of things like their financial history, income, debt, and credit score. Generally speaking, the better the credit score, the better the chance to receive a lower interest rate on the loan. The higher the interest rate, the more money the loan will cost over its term.

Recommended: How Do I Get the Best Interest Rate on a Loan?

The Personal Loan Application Process

While it’s not as simple as walking into a bank, asking for a loan, and walking out with a check, the application process for personal loans is fairly straightforward.

Things to consider include how much money you want to borrow, how much you can afford to pay each month, how long you want to make payments, and whether to put up collateral. There may be other considerations for specific financial circumstances, which can vary from person to person.

Checking Your Own Credit

Because lenders will be looking at your creditworthiness as closely as you’re looking at them, it’s a good idea to give your financial health a checkup before you begin the application process. Checking your credit report at AnnualCreditReport.com , which is free, is a good way to review the report for any errors. Correcting anything that isn’t accurate means your credit report will look as good as possible to lenders.

Comparing Loans

Just like shopping around for the best prices before making any large purchase, comparing lenders’ rates and terms is a smart move before the application process actually begins.

Here are some questions you may want to ask prospective lenders:

•   How much do you lend on personal loans? If the amount you need to borrow doesn’t fall within the range offered by the lender, you may need to look elsewhere.

•   Do you charge any fees or penalties? Some lenders charge an origination fee equal to a percentage of the loan amount to process your application. Some personal loans also have a prepayment penalty if you pay off your loan ahead of schedule.

•   How are fees and penalties charged? Some lenders may roll any fees into the loan amount, which increases the total amount you’ll owe. Other lenders may deduct the fee amounts from the loan proceeds, so the amount you receive will be lower than the actual amount of the loan. The option the lender uses will be stated in the loan agreement.

•   Can I get prequalified so I’ll know what interest rate you might offer me? Prequalification involves the lender doing a soft credit pull on your credit report, which will not affect your credit score. This step will give the lender a sneak peek at your financial history so they can give you an estimated interest rate. Going through this process with multiple lenders is one way to compare rates and terms you may qualify for.

•   What if I can’t make my loan payments due to financial hardship? Missed or late payments could result in late fees, affect your credit score, or lead to your account being sent to collections. Some lenders may offer protections for borrowers who have lost their job or are having difficulty making their payments for other reasons.

Applying for a Loan

When you’ve selected a lender, it’s time to submit the actual application. Lenders typically require a photo ID, proof of address, and proof of income or employment for an unsecured personal loan. Each lender has different requirements, though, so it’s important to submit information that your particular lender requests. At this stage, the lender will usually do a credit check, which could affect your credit score.

Waiting for Approval

When the application and all required documents have been submitted, it’s time to play the waiting game. Rest easy, though, because some personal loan approvals happen quickly — sometimes in just a day. More complicated applications could take up to about 10 days.

Personal loans can range anywhere from $1,000 to $100,000, depending on the lender. Once you apply and are approved for the loan, you’ll receive the amount of money you were approved for in a lump sum, minus any origination fees that some lenders may charge. Then you pay back that money in installments which are set by the specific terms of your loan.

Types of Personal Loans

There are a variety of different types of personal loans. Factors like how much money you plan to borrow, your credit and financial history, and how much debt you already have will influence which type of personal loan is right for you. Here are some different types of personal loans.

Unsecured vs Secured Personal Loans

An unsecured personal loan is the most common type of personal loan. Unsecured means the loan is not backed by collateral, like a house or car. The approval and interest rate you receive on an unsecured personal loan is mostly based on your creditworthiness. Personal loan interest rates on average typically range from 5% to 36% and the repayment terms often vary from one to seven years.

Collateralized personal loans require an asset to be pledged to “secure” the loan. Think of a house when it comes to a mortgage loan, or a car when it comes to a car loan. If you fail to repay your loan, the lender can then seize the collateral.

Some banks offer secured personal loans that allow you to borrow against the equity of your car, personal savings, or other assets. Since secured loans are backed by an asset that the lender can seize if you default on the loan, they generally have a lower interest rate than an unsecured personal loan.

Fixed Rate vs Variable Rate Personal Loans

Most personal loans are fixed-rate loans, meaning your rate and monthly payment stay the same — are fixed — for the life of the loan. Fixed-rate loans can make sense if you’re looking for something with consistent payments each month. A fixed-rate loan is also worth considering if you are concerned about rising interest rates on longer-term loans.

As the name suggests, the interest rate on a variable-rate loan can fluctuate over the life of the loan. Interest rates on this type of loan are tied to benchmark rates or indexes. Based on how the benchmark rate or index changes, the interest rate on a variable-rate loan will also change, directly affecting your monthly payment.

Generally, variable-rate loans carry lower annual percentage rates (APRs) and some have limits on how much the interest rate can rise or lower over a specific period, or even over the life of the loan. A variable-rate loan could be a good choice if you are taking out a small amount of money with short repayment terms.

Choosing between variable vs. fixed rates will come down to personal preference and what you are approved for.

Small vs Large Personal Loans

Just as personal loans are taken out for a variety of reasons, the dollar amount borrowed can vary, too.

A small personal loan, which is generally for $3,000 or less, typically has a lower APR than other types of short-term debt, such as payday loans. Many banks and other financial institutions have limits on the minimum amount they’ll lend. Some credit unions may offer alternatives to payday loans in an effort to help their members save money and avoid being stuck in a cycle of debt.

A large personal loan might be used to pay for major expenses such as home repair or remodeling, medical expenses, or an expensive life event, such as a wedding. Some lenders offer personal loans up to $100,000.

It’s important to keep in mind your ability to repay the loan when deciding how much to borrow.

Want to see if a personal loan
is the right choice for you?
Check out SoFi personal loans.

What Determines the Kinds of Loans You Can Get?

Lenders typically look at an applicant’s credit score, debt-to-income (DTI) ratio, and other factors.

Credit Score

A person’s credit score shows lenders what the theoretical likelihood of that person paying back a loan would be. Generally, the lower a person’s credit score, the more of a risk they are assumed to be. Conversely, the higher a person’s credit score, the lower a risk they are assumed to be.

Debt-to-Income Ratio

Your DTI is the amount of debt, in relation to your income, you have. It’s expressed in a percentage and, ideally, is no more than 36%. Lenders prefer that no more than 28% of your debt be housing related, i.e., rent or mortgage.

Credit History

Lenders will review your credit report for anything that might stand out as a risk for them. If there are a high number of inquiries on your credit report or if there were multiple debt accounts opened in a short time period, that might indicate high risk to a lender.

Paying Back a Personal Loan

Personal loans are repaid over a number of months or years. This is called the loan term and is typically anywhere from one to 7 years. Each monthly payment includes principal — the amount of money borrowed — and interest amounts, and the loan is amortized over the loan term.

Amortization refers to how the loan payments are divided in each monthly payment, over the life of the loan. Even though the total monthly payment remains the same, the amounts being directed to principal and interest will change each month.

An amortization schedule shows the breakdown of each monthly payment, so you’ll know exactly how much of your payment is going towards paying down the principal and how much is being paid in interest.

In the earlier part of a loan’s term, the monthly payment will be mostly interest, with a smaller amount being applied to the principal. As the loan term progresses, the principal payments become larger and the interest payments become smaller.

Personal loans with longer terms may offer lower monthly payments, but that also comes with a higher overall interest cost. A shorter-term personal loan can have higher monthly payments, but cost less overall in interest. A personal loan calculator is a helpful tool to compare loans with different rates and terms.

The Takeaway

Personal loans can offer flexibility when you’re looking for funds for a variety of uses. Depending on your financial needs and your financial circumstances, there may be a personal loan that fits. Comparing multiple lenders is a good way to make sure you’re getting a personal loan that works for you.

As you compare lenders, consider applying for personal loans online. SoFi Personal Loan amounts range from $5,000 to $100,000.

There are no prepayment penalties, and if you unexpectedly lose your job, SoFi Personal Loans include unemployment protection, allowing those eligible to suspend monthly payments in three-month increments for up to 12 months (though interest will continue to accrue), and receive job placement assistance in the meantime.

If you’re ready to take out a personal loan, start by taking two minutes to see what SoFi can offer you.

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Checking Your Rates: To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. However, if you choose a product and continue your application, we will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and may affect your credit.
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