How Personal Loans Work and Common Traps to Avoid

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Updated on Monday, October 29, 2018

how a personal loan works

Need money to pay for a kitchen renovation? Maybe you’d like a chunk of cash to pay off your high-interest credit card debt? An unsecured personal loan can help you accomplish these goals.

Because personal loans aren’t typically backed by any form of collateral, such as a home or car, you don’t need home equity or a vehicle to qualify for one. You do, however, need to do your research before applying for a personal loan. Here’s what you need to know and consider.

How personal loans work

You can apply for personal loans at banks, credit unions or through online lenders. And you often don’t have to put up any collateral to do so.

Unsecured personal loans are different from other types of loans, such as mortgages and auto loans. Those loans are backed by collateral. When you take out a mortgage, your home acts as the collateral, providing a safety net for your lender. If you stop making payments, your lender can take your home through a foreclosure process.

With an unsecured personal loan, there is nothing for a lender to take back should you stop making your payments. Because of this, this type of loan is riskier for lenders.

You can use the funds from a personal loan to pay for a variety of things, such as:

Personal loans come with terms that are usually pretty simple:

  1. There is a fixed term. You know when the debt is paid off, and it is almost always less than 5 years. (Pay the minimum due on your credit card, and you could still be paying 30 years from now). There usually aren’t pre-payment penalties, but some loans do have them, and you should check for that before you accept the loan.

  2. There is a fixed interest rate. Your monthly payment and interest rate stays the same for the life of your loan. Credit cards will increase the interest rate on your existing balance if you become 60 days past due. And they can increase your interest rate on future purchases at any time.

It’s important to compare multiple offers when signing up for a personal loan. Click “see offers” below to compare up to five personal loan lenders to find the best for your needs!


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LendingTree is not a lender. LendingTree is unique in that you may be able to compare up to five personal loan offers within minutes. Everything is done online and you may be pre-qualified by lenders without impacting your credit score. Terms Apply. NMLS #1136.

As of 17-May-19, LendingTree Personal Loan consumers were seeing match rates as low as 3.49% (3.49% APR) on a $10,000 loan amount for a term of three (3) years. Rates and APRs were based on a self-identified credit score of 700 or higher, zero down payment, origination fees of $0 to $100 (depending on loan amount and term selected). Terms Apply. NMLS #1136

Applying for a personal loan: What factors lenders consider

Because personal loans often don’t require collateral, lenders are taking on more of a risk by lending you money. Because of this, lenders will look closely at your credit score and other factors when determining your eligibility for loan funds and what interest rate they will offer you.

Credit score

The higher your credit score, the more likely you are to qualify for a personal loan at a lower interest rate. That’s because borrowers with higher credit scores tend to have a history of making on-time payments each month.

How high should your credit score be? That varies from lender to lender. In MagnifyMoney’s personal loan marketplace, you’ll find lenders who require a minimum score as low as 525. Other lenders require a minimum 710 credit score.

When lenders check your credit score, chances are they will look at your FICO Score. This score ranges between 300 and 850, with 850 being the highest score possible. Here’s a breakdown of the FICO Score ranges:

  • 800+: Exceptional
  • 740-799: Very good
  • 670-739: Good
  • 580-669: Fair
  • 579 and below: Poor

You can view your credit score for free at the three major credit bureaus once per year or you can sign up for free credit monitoring services with My LendingTree (LendingTree is the parent company to MagnifyMoney).  If you find that you have a low score, try following these steps to improve your score.

Debt-to-income ratio

Lenders will also look at your debt-to-income ratio. Different lenders will have different standards for debt-to-income ratios. Most lenders, though, want your total monthly debts to consume no more than 43% of your gross monthly income.

View our video below to get a better understanding of how personal loans work and what factors lenders consider!

How much can you borrow with a personal loan?

Banks and lenders have limits to how much you can borrow with a personal loan. These will vary by institution, so you’ll need to do your research before you apply, especially if you need to borrow a significant amount of money.

At Pentagon Federal Credit Union, for example, you can borrow $500 and $20,000. At Discover Bank,  you can borrow between $2,500 and $35,000. Other lenders, however, may let you borrow up to $100,000.

How long do you have to pay back a personal loan?

Once you’re approved for a personal loan, your lender will provide you with a schedule of payments. This will spell out how much you pay each month, and how many payments you’ll make. It will also list your interest rate and annual percentage rate (APR). APR is the best measure of how much your loan will cost you. APR includes your loan’s interest rate and any additional charges levied by your lender.

How long it takes you to repay your personal loan depends on your lender and the loan term you sign up for. Most banks, though, offer personal loans that you pay back over one to five years.

For example, USAA Bank offers loan terms for 12 to 48 months. Discover offers terms between 36 to 84 months.

How much do personal loans cost?

Banks and financial institutions make their money with personal loans through the interest they charge you for borrowing money. You want to make sure when applying for a personal loan that you know exactly how much you will pay each month in interest.

The interest rate your lender charges will depend largely on your credit score and debt-to-income ratio.

Rates with personal loans, though, tend to be higher than they are with mortgages, auto or home equity loans. That’s because personal loans don’t require collateral, so they are riskier for lenders. To make up for that risk, lenders tend to charge higher interest rates.

What rates can you expect to pay? LightStream offers APRs between 4.99% and 19.99% with autopay, while Upstart has rates between 8.69% and 35.99%.

Some lenders will charge an origination fee to draft your personal loan. It’s not uncommon to see fees ranging from 1% to 8% or more of your loan amount. Many others, though, will not. In general, you should avoid paying an origination fee.

Click here to view the best options for a no fee personal loan on our site.

Personal loan pitfalls to avoid

Personal loans do come with some advantages over, say, using your credit card. The interest rates are lower and you’ll have a fixed monthly payment, so you can more easily budget your payments.

But there are some potential traps you should avoid when signing up for a personal loan.


We all want to protect our families from the unexpected and insurance is a great way to do just that.  Similar to how we recommend planning in advance for your debt (and looking for your best deal), you should do the same with insurance. However, many personal loan providers will try to add an insurance sales pitch at the end of a loan closing.  The two most typical types of insurance are life insurance and unemployment insurance.

For life insurance, a typical sales pitch would sound like this: “for just the cost of a can of soda a day, you can make sure your children never have to worry about this debt if you die.” Beware these high-pressure sales tactics.  The value of these add-on policies is almost always outrageously bad.

To protect your family, you should think about a good term life insurance policy that covers not just your personal loan, but all of your needs.  Do this search separate from the loan transaction.

Unemployment insurance could be a bit more compelling (because, unlike term life insurance, it is difficult to buy a policy separately that would make loan payments on your behalf if you lose your job).  I have seen people benefit from these policies.  But you need to do the math.  How much does it cost per month?  So long as you don’t have a high risk of losing your job in the next 6-12 months, you are almost always better off saving the money (rather than paying the premium).  There are also a ton of limitations to the amount of the loan payment that can be made (and the length of time that it will be paid).  You should ask them the following questions:

  1. How much does this cost a month?

  2. What are the requirements for me to be able to claim?

  3. How much would it pay and for how long?

When you ask those questions, you will likely see that the policy being offered is poor value, and you are better to just save the money yourself.

High interest rates

Depending on your credit score and lender, you could face high interest rates when taking out a personal loan. A high interest rate will result in a higher monthly payment.

In fact, if you qualify for an APR as high as 35.99% — which some lenders charge to customers with poor credit — you might not save any money over using a credit card if you have one.

Precomputed interest

Ask lenders how your interest is computed. What you don’t want to hear — and a situation that you want to avoid — is that your interest is calculated on a precomputed basis. The essence here? Precomputed interest is not a good deal for customers who might pay off their personal loans early.

The Consumer Financial Protection Bureau does a good job of explaining how precomputed interest works. At its most basic, though, when lenders precompute your interest, you will pay a greater amount of interest from earlier months and years of your personal loan. This won’t happen if your interest is computed using the simple interest method.

If you take the full term to pay off your personal loan, there is no difference between the simple and precomputed methods. You’ll pay the same no matter what. But if you pay off your personal loan before its term ends — say you pay off a five-year loan in just three years — you will pay more in interest under the precomputed method. That’s because you’ll be paying more interest in the earlier months of your loan than you would under the simple interest method.

In short, if you plan to pay off your loan early, avoid precomputed interest.

Origination fees

As mentioned earlier, there are plenty of lenders that don’t levy origination fees, the charge filed by lenders for originating your loan. If you can’t qualify for a personal loan with a lender that doesn’t charge an origination fee, you might consider skipping out on such a loan altogether.

That’s because origination fees can be costly.

Lenders that do charge origination fees vary in how high they are. Online lender LendingClub provides a good example. The lender says its origination fees range from 2.00% - 6.00% of your total loan amount, depending on your credit score.

For example, if you take out a $6,000 personal loan with an origination fee of 3.5%, you’d have to pay $210. This amount may reduce the amount of money you receive. LendingClub says that it subtracts your origination fee from your loan. This means that the money you receive will be less than what you were approved for.

Here’s an example provided by LendingClub: If you take out a $6,000 personal loan with 3.5% origination fee with their ongoing interest rate, you’d receive a total of $5,790 in your bank account. That equals $6,000 minus the $210 origination fee.

Prepayment penalties

Another way lenders can hit your finances is with prepayment penalties. As the name suggests, these are fees borrowers must pay if they pay off a loan too early.

Say you take out a personal loan with a term of five years. Your lender might charge you a prepayment penalty — usually a percentage of your remaining balance — if you pay ahead and pay off your personal loan in just two years.

The good news is that most lenders don’t charge prepayment penalties on personal loans, meaning that you should be able to avoid them. Just make sure you ask any lender with which you work if they do charge these fees.

Personal loans are great, if you do the research

With a personal loan, you can have a fixed interest rate, fixed payment, and fixed term.

If you compare APRs, then you will be making the right decision. Don’t just jump into picking a personal loan and end up taking out a pre-computed loan, with three add-on insurance policies and a big origination fee – only to refinance the loan three months later.  These are sub-prime tricks that can dramatically increase the costs.

If you borrow for 36 months and pay it off in 36 months, then you are in good shape.


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