How Do Personal Loans Work?

Find out when, why and how to get a personal loan.

When you’re strapped for cash, you might want to consider taking out a personal loan to help you close your budget gap. People take out personal loans for a variety of reasons, from covering educational expenses to paying off debt to completing home improvement projects.

Don’t confuse a personal loan with an emergency fund, however. Understand that your emergency fund is rather sacred — and you must use it only for true emergencies, like if you lose your job, have a medical emergency, experience a death in the family or have to take care of an emergency home or car repair.

Low-interest personal loans can be a good solution if you need money quickly. Cash loans aren’t the only answer anymore when you need money right away. These days, you can get a decision in as little as a few minutes and get funded the next business day. Before you sign on the dotted line, however, there are a few things you should know. Keep reading to find out how personal loans work and other information so you can find the best personal loan available.

How Personal Loans Work

What is a personal loan? Because personal loans don’t require any collateral or down payment, they are unsecured loans. You can get a personal loan from a wide variety of banks, credit unions and personal loan companies — and it’s a good idea to shop around for the best personal loans and compare different financial institutions’ interest rates, loan terms and other fees.

Your lender will check your credit score to determine whether or not to give you the loan. Depending on your history, your interest rate could be higher on this type of loan than on a secured loan. You will get a fixed repayment term with your personal loan, which will typically be anywhere from two to five years. In addition, you’ll likely get a fixed interest rate.

Personal loans usually come with lower interest rates than credit cards, which makes for affordable borrowing. They do, however, typically come with higher interest rates than secured loans, so check the APR before you sign.

When to Get a Personal Loan

Some situations lend themselves to personal loans. Also, you can use a personal loan to pay for anything you want, unlike student, auto or mortgage loans. Here are some effective ways to use a personal loan:

  • Pay off high-interest debt. When you have a lot of high-interest credit card debt, it might be a good choice to take advantage of personal loan rates to pay it off. Not only will you save money on interest payments, you’ll know the debt will be paid off at the end of your loan term.
  • Consolidate debts. Consolidating your debts is a bit different from paying off your high-interest debt. Regardless of your other loans’ interest, you could use a personal loan to pay them all off. That would likely make it easier for you to manage your bills, and you’d have lower monthly payments.
  • Pay for something you need. Say you need to take a professional development coursework and you don’t have the cash upfront, or you need money to pay for medical expenses you know are down the road. A personal loan could be a good solution in both cases.

Learn: Here’s How Much You Can Borrow With a Personal Loan

How to Get a Personal Loan

You must assess your finances before you apply for a personal loan to make sure it’s the right move for you. Here’s what you need to do to get a personal loan:

1. Assess Your Financial Situation

First, consider how a personal loan will impact your finances — try using a personal loan calculator to find out how much your monthly payments would be. Keep in mind that people with good credit have an easier time getting an unsecured personal loan because they pose less of a risk to the lender. That doesn’t mean there aren’t personal loans for bad credit. In case your credit isn’t stellar, think about asking someone to co-sign.

2. Do Your Own Credit Check

A lender will check your credit, so you should know what it’s like before you apply. To check your credit, request a credit report from AnnualCreditReport.com. You’re entitled by law to get one credit report from each of the major credit bureaus per year, so take advantage of it. Review your credit report carefully and dispute any errors or discrepancies.

3. Research Your Lender

Find a lender who can provide you with solutions. Shop around for the best deal, then research your lender online to see what borrowers have said. It’s essential you have a lender you trust.

 

Find Out: How Do Banks Decide My Personal Loan Eligibility?

4. Gather Your Documents

You will need a number of documents to apply for a personal loan. The most common ones include:

  • Passport or driver’s license
  • Social Security card
  • Proof of residence, such as a utility bill or signed lease
  • Proof of income, such as a paystub

5. Apply for Your Loan

You can always take your documents and visit a branch of your bank or credit union to apply for a loan, but so many lenders offer applications for personal loans online that you could also apply for quick personal loans at home. Online applications for personal loans apps are usually straightforward, and you might get a decision in as little as a few minutes.

Related: 10 Best Personal Loans for People With Good Credit

6. Make Your Payments

Once you secure your loan, make timely payments. Even paying a few days late can ding your FICO score, and if the loan goes to collections, it will have a significant negative impact on your credit.

When to Avoid Personal Loans

A personal loan isn’t always the answer to a financial need. Here are some things that you definitely shouldn’t take out a personal loan for:

1. Refinance Student Debt or Pay for College

Don’t use a personal loan to pay for college. Instead, use private or federal student loans — they don’t require a credit check, the interest is tax deductible and interest rates are typically lower than personal loans. Instead of paying off student loans with personal loans, consider private student loan refinancing — you’ll likely get far lower rates, and you’ll get a tax deduction for the loan.

2. Consolidate Smaller Debt

Don’t take out a personal loan to get rid of credit card balances if you can pay them off within 12 to 18 months because it might be too much hassle for not enough reward. Instead of looking at small personal loans, try a balance transfer with a zero-interest credit card, which can serve as a way to consolidate your debts.

3. Finance a Car

Instead of taking out a personal loan to pay for a car, consider an auto loan. An auto loan is a secured debt, which means it is backed by collateral — the car you buy. When you don’t pay your bill, the lender can repossess it and sell it to recover his loss. Because there is less risk to the lender with a secured personal loan, it’s usually easier to get one and the interest rates tend to be lower than personal loan interest rates.

4. Pay for a Vacation

Fact: A vacation is a luxury, not a necessity. You probably can’t afford it if you need to take out a personal loan. Plus, you’ll be paying interest on the money you borrow, so your vacation will cost even more. Plan a less-expensive trip instead and save up for the big splurge.

Up Next: 10 Common Personal Loans — and Options for When You Can’t Qualify