What Is a Personal Loan?

A personal loan is money borrowed from a lender that you pay back in monthly installments.

Jackie VelingNovember 6, 2020
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A personal loan is money borrowed from a bank, credit union or online lender that you pay back in fixed monthly payments, or installments, typically over two to seven years.

Though it’s usually best to dip into your savings or emergency fund to cover unexpected expenses, personal loans can be a good option for non-discretionary purposes, like debt consolidation.

How do personal loans work?

Most personal loans are unsecured, meaning they’re not backed by collateral. Lenders decide whether to give you an unsecured loan based on factors such as your credit score, credit history, debt-to-income ratio and free cash flow.

If you don’t qualify for an unsecured loan, you may be offered a secured or co-signed loan. Secured loans are backed by an asset like your home or car, and the lender can repossess your property if you default. Co-signed loans include an additional applicant with a strong credit profile who will help guarantee the loan; they are responsible for missed payments.

Other types of personal loans include fixed-rate loans, in which your rate and monthly payments stay the same, or variable-rate loans, in which your rate and payments change.

How to pick the best personal loan

One of the best ways to evaluate a personal loan is to look at the loan’s annual percentage rate. The APR is the total cost of borrowing and includes the interest and any fees.

For example, if you take out a $10,000 personal loan at 18% APR, with a 24-month repayment period and monthly installments of $499, you would pay a total of $11,976, according to NerdWallet’s personal loan calculator.

Lender rates can range from around 6% to 36% APR. You'll want to compare rates from multiple lenders before applying. The loan with the lowest APR is the least expensive and usually the best choice.

How personal loans affect your credit score

A personal loan affects your credit score much like any other form of credit. On-time payments will build credit, while late payments can damage your score if they’re reported to the credit bureaus.

Applying for the loan will also affect your score. Most lenders allow you to pre-qualify with a soft pull, which won’t hurt your score. Once preapproved, formally applying triggers a hard pull, which typically knocks off less than five points from a score and stays on your credit report for two years.

What can I use a personal loan for?

Personal loans can be used for almost any purpose. Common uses include debt consolidation, home improvement projects, medical bills and refinancing an existing loan.

Loans can also be used for other purposes, like paying for a wedding, vacation or other a purchase.

When to use personal loans

A personal loan should help you reach your financial goals rather than contribute to a debt problem, which is why we recommend using one only when it saves you money, improves your income-generating capabilities or helps increase the value of something you own.

For example, a home improvement project could increase the value of your home, and a loan may make sense if you don’t have a lot of equity in your home or you don’t want to use your home as collateral.

A personal loan can also be a smart way to consolidate multiple forms of debt if the loan has a lower interest rate. With this type of loan, you would use it to pay off what you owe, then make fixed monthly payments toward the personal loan.

Alternatives to personal loans

For discretionary expenses, consider cheaper alternatives than personal loans.

A 0% APR credit card can be one of the best ways to borrow money, particularly if you pay the balance back within the card’s introductory period. This period can last up to 18 months, and no interest will be charged on your purchases.

You need good to excellent credit — above 690 FICO — to qualify for a 0% card.

A personal line of credit is another alternative. These are most commonly offered by banks and are a hybrid between a loan and a credit card. Like a loan, a lender will need to approve your application, but like a credit card, you draw only what you need and pay interest only on the amount you use.

A line of credit is ideal for borrowers who aren’t sure what their total borrowing need will be. Those with good or excellent credit have the best chance at getting approved at the lowest rates.

How do I get a personal loan?

A strong credit profile gives you a better chance of qualifying for a personal loan and getting a lower interest rate. However, there are lenders who offer fair credit and bad credit loans.

Some lenders also prioritize alternative data, or anything not on your credit report, when evaluating applicants, including education, occupation and where you live.

Applying for a personal loan

First, you'll want to pre-qualify with multiple lenders to compare offers. Pre-qualifying takes only a few minutes, and you’ll need to provide information like the loan’s purpose, the loan amount, desired monthly payment and your basic personal details.

After you’ve selected the best offer, you’ll gather documents for the formal application. This usually includes a photo ID, proof of address, proof of employment status, education history, financial information and your Social Security number.

Most lenders now have an entirely online application, so you can complete your application through a desktop or mobile device.

After you're approved, you could be funded as early as the same day.

Paying back a personal loan

Personal loans are like any other debt: You should have an understanding of how the monthly payments change your budget and a clear plan to pay off the loan.

This could mean revisiting your budget and adding in your monthly payment, as well as keeping an eye on any refinancing opportunities to take advantage of an even lower rate.

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