What Is a Personal Loan & How Do They Work?
Financial goals, larger purchases and unexpected expenses can drive the need for an infusion of cash. Personal loans give borrowers a structured way to get access to the money they need in return for paying back the loan, with interest, to a lender.
If you need a quick infusion of cash, it’s important to fully understanding what a personal loan is, how they work, when you should use them and the pros and cons. This information is essential to reaching your goals and protecting your overall financial picture.
Personal loan definition
A personal loan is a lump sum of money that you borrow from a bank, lender or financial institution that you pay back in installments with interest over a fixed period of time. Some of the more common personal loans include unsecured loans, secured loans, debt consolidation loans, small business loans and home improvement loans.
Typically, there are few limits on what you can use a personal loan for, which is a nice feature. The downside to that, though, is that most personal loans are unsecured, so interest rates can be — and often are — higher. The proposed changes to FICO credit scores with the rollout of FICO 10-T may also include flags to consumers who use personal loans as they can be riskier forms of lending.
How do personal loans work?
Securing a personal loan can be done through a bank, credit union, lender or other financial institution that offers loans. As with any loan, you’ll need to fill out an application, provide the necessary documentation and wait for approval.
When you’re approved, the lender will notify you of the amount of money you are approved for as well as what your interest rate on the loan will be. Typically, the rates on personal loans will be higher, but how much higher will be dependent on your credit score, creditworthiness, where you live and the amount of money you’re trying to borrow.
You and the lender will also have to agree on the repayment terms. You’ll receive all of your money in a lump sum and then you will make payments back, usually on a monthly basis. Your payments will include funds going toward the principal — which is the amount you borrowed — and funds going toward the interest, which is the cost of the loan. Loan repayment terms can be as short as a few months to as long as a few years.
Advantages of personal loans
Easier to acquire
Collateral is something you agree to give to a lender if you default on your loan. For example, collateral on a mortgage is your house. If you are unable to make your mortgage payments, the bank or lender can take your house to try and recoup some of the lost money. Most personal loans don’t require collateral and are easier for many people to acquire because they’re usually for much less money than a mortgage or car loan. The lender will still look at your credit score and creditworthiness, but they are more likely to lend to more people on different ends of the credit spectrum when it comes to personal loans.
Help build credit history
Your credit score shows lenders a snapshot of how reliable you are with paying back money you’ve borrowed. While a personal loan may have a negative impact on your credit score in the short term by lowering your average age of accounts and increasing the amount you owe, it may help to build a positive credit history over the long term.
If you make all your payments on time and demonstrate you’re a responsible borrower, your score will go up. A higher credit score may help you to get better borrowing rates in the future and may allow you to qualify for less risky loan types in the future.
May help to manage existing debt
If you have significant debt owed to multiple lenders, you may be able to use a personal loan to consolidate your debt. Effectively, the new lender pays off all of your existing debt, bundles it together and then charges you a lower overall interest rate than you would have paid on the credit cards.
In turn, you no longer have to write payments to multiple lenders and you can save on your overall interest payments. It’s important to note that this is not the same as debt settlement, which generally allows you to settle your debts for less than is owed and can be devastating to your credit.
Drawbacks of personal loans
May hurt credit score in the short term
In the short term, personal loans have the potential to lower your credit score. For one, they add debt to your report, which will lower your score. Second, FICO, the leading company for credit scoring, has hinted they may be increasing the negative effects of an outstanding personal loan on your credit score in the coming future. Again, though, if you make all your payments on time, these negative impacts should be short-lived. The end result should be a better credit score.
Higher interest rates/cost
You can expect to pay higher interest rates regardless of your credit score due to the fact that personal loans are usually unsecured. Borrowers with better scores should be able to pay lower rates than borrowers with subpar credit scores, but those interest rates will still be higher than with secured forms of borrowing.
While higher interest rates are not ideal, they may be your only option to get the funding that you need. If you don’t have access to other less expensive forms of funding, you may have to bite the bullet and accept the more expensive money.
Size of the loan
Unsecured loans are riskier for lenders, as they have little recourse if you default on the loan. Because of this, many lenders limit the size of personal loans they are willing to extend. If you need a very large sum of money, you may not be able to get it through a personal loan.
While personal loans are probably not the first choice on a lot of people’s list of borrowing options, they can be an effective source of funding when you’re short on options. You will pay more for the money borrowed due to interest and fees, but the funding should be easier to secure.
Ultimately, if you have a need for an infusion of cash, you should weigh all of your options. In many cases, personal loans will be the best and most fitting borrowing option, but it will depend on your needs and circumstances.