How do personal loans work?

Types of personal loans: secured vs. unsecured

Loans fall into two general categories: secured and unsecured. Depending on the purpose of your personal loan and your financial situation, your lender may offer one or both.

How do secured personal loans work?

Secured personal loans require collateral — something that you put down as a guarantee you’ll repay. If you fail to make payments on time, the lender can take possession of the asset you’ve provided as collateral and sell it to get its money back. Monetary savings, a vehicle and real estate are all popular examples of collateral.

The most common types of secured loans are mortgages and auto loans. Since having collateral reduces risk for the lender, the interest rates on secured loans tend to be lower than unsecured loan rates, and you can often borrow more money for a longer time.

Though secured loans are often more affordable, there is a greater risk to the borrower. It's important to recognize that you could lose a valuable possession if you fail to pay back the loan.

How do unsecured personal loans work?

Most personal loans are unsecured and have no asset serving as collateral. These loans, also called signature loans, are riskier for lenders — if you miss payments, the lender can’t use your property to recover its losses. This is why unsecured loans tend to have higher interest rates.

Your credit score, income and debt-to-income (DTI) ratio all determine how much you can borrow and what rate you pay. To get an unsecured personal loan with lower rates and fees, you usually need a credit score of around 670 or better.

» MORE: Personal loan vs. credit card: Which is better?

Interest rate on personal loans: fixed vs. variable

Another factor to consider is whether a personal loan has a fixed or variable interest rate — this affects your monthly payment and how much the loan costs overall.

How do fixed-rate personal loans work?

A fixed-rate personal loan means the interest rate remains the same until you pay off the loan. This offers predictable monthly payments.

Fixed-rate personal loans often have a higher starting interest rate compared with a variable rate, but the predictability for your budget may outweigh that potential benefit.

How do variable-rate personal loans work?

A variable-rate personal loan means your interest rate fluctuates, which also means your monthly payment can change. The interest rate changes according to an index rate that’s specified in your loan documents.

“The ability to predict payments in a fixed-rate personal loan is better, unlike a variable-rate personal loan, whose interest rate fluctuates, making it hard to budget,” explained Fred Winchar, the CEO of Max Cash, an online loan broker.

“Sometimes, when the market interest rates increase, the rate of a variable-rate personal loan might skyrocket, making it hard to make your monthly repayment,” Winchar said.

Applying for a personal loan

You can apply for a personal loan through a bank, credit union or online lender. Most financial institutions offer online loan applications.

To expedite the application, be prepared to answer questions about yourself and your financial situation, and have the following documents ready:

• Government-issued ID
• Social Security number
• Income verification, such as pay stubs, W-2s or bank statements
• Proof of residence, such as a utility bill, rental agreement or mortgage statement
• Bank account information 
• Information about assets and debts

Once you submit your application, the lender will conduct a hard credit pull. This temporarily decreases your credit score by a few points.

When your application is approved, you will have a chance to view and approve your rate and repayment terms.

» MORE: How to apply for a personal loan in 5 steps

Approval for a personal loan

To get a personal loan, you need to meet a lender’s eligibility requirements. These qualifications differ by lender, but the main factors that lenders consider are:

• Credit history and score: “Credit history can make a difference — a borrower’s credit score and credit history is important in getting the best loan rates,” said Winchar. “Based on the credit score and credit history, they might get a better interest rate, which can reduce the overall cost of the loan.”
• Employment/income: Lenders want to see that you have a regular and stable source of income so you can pay back the loan. Your income helps determine how much you can borrow. Be prepared to show pay stubs, tax returns, W-2s, bank statements and employer information.
• Debt-to-income ratio: Your DTI ratio shows how much of your gross monthly income goes toward paying debts, like housing or a car payment. Lenders will ask you to list all these debts. Lenders set their own DTI ratio qualifications — a ratio of 35% to 40% or below is a standard requirement.

Repaying a personal loan

Personal loan repayment plans consist of monthly installment payments until the entire amount, plus interest, is repaid. You will make a payment each month by the due date set by the lender. The monthly payment goes toward both the loan principal (the amount you borrowed) and the interest charges (the costs of borrowing).

You may strive to pay off the loan early, but be aware some personal loans come with a prepayment penalty. This charge may be a percentage of the loan or a flat fee.

The lender can charge other fees, too, such as a late payment fee if you submit a payment past the due date.

What can a personal loan be used for?

You can use a personal loan for almost any legal purpose. Some examples of things borrowers use personal loans for include:

• Consolidating high-interest debt
• Making a home improvement
• Paying medical bills
• Getting a motorcycle or car
• Repairing a vehicle
• Buying a boat or RV
• Paying for a wedding or a trip

Keep in mind that some lenders may offer personal loans for specific purposes, such as debt consolidation. When you apply, it’s common for the lender to ask how you plan to use the funds.

Some lenders exclude loans used for businesses, investments, educational expenses and house deposits, so it’s important to confirm any limitations for using the funds.

Bottom line

A personal loan can help cover almost any expenses you have and, when paid off on time under the terms of the agreement, can also help improve your credit. These loans are flexible when it comes to amounts and terms, and they can be a great help to someone who needs funding quickly.

If you qualify for a personal loan and can afford one, it may make sense to consider this borrowing route. Just make sure you compare offers from multiple lenders before choosing the one that’s right for you.