How Personal Loans Work: Everything From Application to Payoff

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Updated on Thursday, October 29, 2020

Personal loans can be used for almost any purpose, from consolidating credit cards to paying for home improvements. But before you apply for one, you should understand how personal loans work in order to get approved for a loan with a competitive interest rate.

Read this definitive guide on applying and qualifying for personal loans so you can make an informed financial decision, however you choose to use your loan.

How do personal loans work?

A personal loan is a lump-sum loan with a fixed APR and fixed monthly payments. When you take out a personal loan, the lender typically deposits funds directly into your bank account, and you can use a personal loan to pay for virtually anything.

Personal loans can be secured or unsecured, depending on whether they require collateral:

  • Secured personal loans are backed by an asset you own, such as your car. If you don’t repay your loan, the lender may seize your assets to recover any losses.
  • Unsecured personal loans are backed only by your promise to repay the lender. Because there’s nothing for the lender to seize if you stop paying the loan, interest rates tend to be higher on unsecured loans.

FAQ: Personal loans

Personal loans typically range from $1,000 to $50,000, but they may come in higher amounts for select borrowers.

Personal loans typically need to be repaid in 24 to 60 months, although they may come with shorter or longer terms.

Personal loan APRs tend to fall between 6% and 36%, but offered APRs vary greatly. Excellent-credit borrowers may be able to secure APRs below 6%, while people with bad credit or no credit will qualify for higher APRs, if they qualify at all.

Personal loan requirements vary by lender. You’ll at least need proof of identification and income to get a personal loan. Lenders rely on your credit score and debt-to-income ratio to determine eligibility.

Online lenders may be able to process your application and disburse funds into your account within a few business days. At traditional banks and credit unions, the same process could take a few days or weeks.

Yes, although you may have to pay a prepayment penalty if you do. Many lenders do not charge this fee, however.

How much do personal loans cost?

Annual percentage rate (APR) is a way of measuring the total yearly cost of a personal loan. It includes your interest rate as well as any fees, such as a loan origination fee. Your APR is the most important factor when looking for a loan, because a lower APR directly correlates to a lower cost of borrowing. The lower your APR, the less money you will pay over the life of the loan.

See how APR affects the total cost of the loan and the total interest paid in the table below:

Cost of a $10,000 loan over 36 months
APR*16.12%20.65%
Monthly payments$352$375
Total cost of loan$12,678$13,498
Interest paid$2,678$3,498
*APRs used are for illustrative purposes only.

Personal loan interest rates vary greatly, so it’s best to shop around for your best possible APR  before taking out a loan. Even just a slightly lower APR can save you money on financing in the long run.

MagnifyMoney’s personal loan marketplace lets you compare up to five personal loan offers within minutes through LendingTree.

How to get a personal loan

Applying for a personal loan is fairly simple. Unlike other loans — which may come with strings attached as to who can apply and how the money can be used — personal loans can be taken out by qualified borrowers for virtually any reason.

Here’s how to apply for a personal loan:

  1. Check your credit. Your credit score will affect your loan eligibility and the terms you receive (see where you stand with this guide). Your score is affected by information on your credit reports. To request your credit report for free from the three major credit bureaus once per year, visit www.AnnualCreditReport.com (reports are also available weekly through April 2021). Dispute any errors using this online guide and sample letter from the Consumer Financial Protection Bureau.
  2. Compare APRs by prequalifying with lenders. Many personal loan lenders can estimate your APR with just a soft credit pull, which won’t affect your credit score.
  3. Choose your best offer, and formally apply through the lender. The lender will analyze your credit history, income and other eligibility factors. This will require a hard credit check, which can temporarily lower your credit score.

Qualifying for a personal loan

Not all borrowers will qualify for a personal loan. To determine if you’re a good candidate for a personal loan, lenders typically look at your credit score and your debt-to-income ratio.

Borrowers with excellent credit scores (think 700 and above) and debt-to-income ratios of 36% or less will have the easiest time qualifying for personal loans, and they’ll also get lower offered APRs. On the other hand, borrowers with bad credit or no credit will have higher offered APRs, if they’re approved at all.

Some lenders advertise minimum credit score requirements to help borrowers determine eligibility without having to pre-qualify. Here are a few personal loan lenders and the minimum credit scores they require:

Lending companyMinimum credit score required
Earnest650
Payoff640
Peerform600
TD Bank Express Loan660

What can you use a personal loan for?

You can use a personal loan for any purpose, from refinancing high-interest credit card debt to paying for your wedding:

Common uses for a personal loan

Personal loans can be useful tools that help you realize your financial goals. However, you should do your research before using a personal loan for discretionary purposes. It’s not always necessary — or even advisable — to borrow money if you can avoid it.

How to consolidate or refinance high-interest debt with a personal loan

By far, the most common uses for personal loans are debt consolidation or credit card refinancing. Borrowers who struggle with high-interest debt, such as revolving credit card balances, may consider opening a debt consolidation loan to save money on interest or pay off debt faster.

Add up all the debts you want to refinance with the personal loan. Borrow too little and you won’t have enough to cover your debts; borrow too much and you’ll end up paying interest on unneeded debt.

Personal loan APRs typically range from 6% to 36%, so you want to make sure the APR is lower than what you’re currently paying on your debts.

Personal loans are lump-sum loans that are typically deposited straight into your bank account. You can pay off credit cards, payday loans and other types of high-interest debt.

 

Find out how much you can save using MagnifyMoney’s debt consolidation calculator.

Pitfalls to avoid when taking out a personal loan

Getting stuck with a high APR loan

Personal loan APRs can be upwards of 36%, which makes it quite expensive to borrow money. For example, the $10,000 loan used in the example above would cost you $6,489 in interest over the course of 36 months if you borrowed it at 36% APR.

The solution: Shop around for your best possible APR before committing to a loan. If you’re only getting personal loan offers with high APRs, consider working on improving your credit score before applying again.

Choosing a personal loan over a better alternative

Personal loans can be the best option in a number of financial situations. However, it’s best to weigh your alternatives before taking out a personal loan. For example, it might not be smart to take out a personal loan for business expenses if you can qualify for a traditional business loan with better terms.

The solution: Depending on the reason why you’re taking out a personal loan, you could consider a different type of loan or financial strategy.

5 common personal loan purposes and their alternatives
Auto financingTraditional auto loans. They tend to come with lower APRs, although they may have more strings attached.
Business expensesSmall business loans. It can be difficult to qualify for traditional business loans or SBA loans, but it can pay off in the form of much lower APRs and other protections.
Credit card refinancingBalance-transfer card. Some borrowers may qualify for a balance-transfer credit card with an introductory 0% APR period. Watch out for balance-transfer fees.
Medical billsNegotiation. You may be able to get your hospital bill reduced or enroll in an interest-free payment plan through the hospital’s billing department.
Wedding expensesBudgeting. Weddings are even more expensive if you’re paying interest on money you borrowed. Save for your big day well in advance so you can pay in cash.

Paying high fees and penalties

Personal loan fees can add up and increase the cost of borrowing money. For example, loan origination fees can range from 1% to 6% of the total cost of the loan, which makes it more expensive to take out a personal loan.

Some lenders also charge a prepayment penalty, which is imposed if the borrower repays the loan before the term expires.

The solution: Not all personal loans carry fees and penalties. Seek out lenders that offer no-fee personal loans.

Borrowing more than you can repay

Living above your means can cost you in the long run. If you don’t repay your personal loan, you risk ruining your finances. The consequences of defaulting on a loan are serious:

  • You may be charged a late fee.
  • Your credit score may take a hit.
  • The lender can take you to court.
  • Your wages may be garnished.
  • You risk losing any assets you used as collateral.

Don’t get in over your head with a personal loan you can’t repay. Before you borrow, it’s important to analyze your finances to see if a personal loan is a good fit for you.

The solution: Use a personal loan repayment calculator to estimate your monthly payment based on the amount you want to borrow and the approximate APR. See if the payment fits into your monthly budget before you take out a loan.