What is a personal loan?

How does a personal loan work?

A personal loan is a short-term loan issued by a financial institution to a borrower. Repayment is typically over one to five years. Most personal loans have a fixed interest rate.

With this kind of loan, you make regular monthly payments until you repay the loan in full. As long as the personal loan has a fixed interest rate, you make the same payment each month for the length of the loan term.

When considering a personal loan, you'll want to be sure to distinguish between secured and unsecured loans. Traditionally, personal loans are unsecured, meaning you don’t have to use an asset as security, or collateral, for the debt.

Types of personal loans

There’s a variety of personal loans available, so understanding your options will help you find the one that best meets your needs.

Loans can be secured or unsecured. If you have a less-than-ideal credit score, you may have more success applying for secured loans because they reduce the lender's risk.

• Unsecured personal loans: An unsecured personal loan is a loan not backed by collateral. If you don’t repay the loan, the lender can’t seize any personal assets without going through legal processes to pursue collection.
• Secured personal loan: A secured personal loan is a loan backed by collateral. If you don’t repay the loan, the lender has the right to seize the collateral. Though a mortgage isn’t a personal loan, it is the most easily recognized example of a secured loan. Typical forms of collateral for personal loans are vehicle titles, jewelry and cash savings accounts.

Typical forms of collateral for personal loans are vehicle titles, jewelry and cash savings accounts”

Loans may also come with a variable or fixed rate. It's essential to understand the difference to avoid being surprised if you take out a fixed-rate loan and your monthly payments change.

• Fixed-rate personal loans: With this kind of loan, the borrower pays the same interest rate throughout the life of the loan. These are more typical than variable-rate loans, and they’re helpful for budgeting because your monthly payment never changes.
• Variable-rate personal loans: A variable-rate personal loan’s interest rate can change over time. The interest rate is usually based on an underlying index. Changes in the rate can lead to an unpredictable monthly payment, but some opt for this option to qualify for a lower introductory rate.

Interest on a personal loan

You might expect the interest rates on unsecured loans to be higher than those on secured loans; it’s riskier to the lender when they don’t have the option to seize collateral. However, this isn’t always the case. Lenders tend to market secured loans toward individuals who can’t otherwise qualify for unsecured loans, so you might find that they require collateral and have interest rates similar to unsecured loans.

Pros and cons of a personal loan

Just as with any financial product, there are benefits and drawbacks to consider with a personal loan. Consider the following pros and cons as you decide whether a personal loan is appropriate for your situation.

What can you use a personal loan for?

One of the most significant benefits of personal loans is that you can use them for nearly any purpose. You might use the funds for:

• Home improvement projects
• Debt consolidation
• Medical emergencies
• Wedding expenses
• Vehicle repair
• Funeral expenses
• Vacations

Personal loans are versatile, but lenders can place restrictions on the use of the funds. You generally can’t use the money for:

• Business expenses
• Illegal activity
• Education expenses
• Real estate purchases

Lenders typically ask for the reason for your loan. Your reason, in some cases, may also affect your interest rate.

Bottom line: Is a personal loan worth it?

The benefits of a personal loan vary widely depending on your situation. When you’re considering a personal loan, it’s essential to weigh the pros and cons to see if it’s the right decision for you. It’s also good to shop around for the best interest rate and terms.

If you’re not careful, personal loans can lead to debt issues and credit problems. However, when used responsibly, a personal loan can be a great way to access funds you need for various purposes. It can also help you build or improve your credit score.