Personal loans are a popular option for consumers who need to borrow for any reason. They are easy to understand, easy to find and take little time to get.
Sometimes borrowing makes sense
You can borrow with a personal loan for any reason. Here are some popular ones:
- Debt consolidation
- Build a credit history
- Pay for travel
- Finance a wedding or other special event
- Cover a medical procedure
- Buy a tiny house
- Fix up your big house
This comprehensive guide tells you what personal loans are, when and how to use them, and how to pay less for a personal loan.
What is a personal loan?
Personal loans are unsecured sources of funds that come with a variety of interest rates and terms. Many companies offer them, and each decides what consumers it wants to serve and what it will charge. Here are the common characteristics of personal loans.
While personal loans can have variable interest rates, the safest come with low fixed interest rates, a monthly payment that won’t catch you by surprise, and a set repayment timeline that lets you know exactly when you’ll be debt-free.
The main characteristic that makes a personal loan “personal” is that is is unsecured. There is no house, car, boat or other property to take away if you don’t pay it back. All the lender has is your personal guarantee. Personal loans are also called “signature loans” or “unsecured loans.”
Other personal loan features:
- Usually (but not always) fixed interest rate
- Closed-end (meaning you repay the loan off over a set term, usually one to five years)
- Usable for any legal purpose
- Approval depends on income, debts and credit rating
- Most loan amounts range from $1,000 to $35,000 (but some companies offer loans exceeding $100,000)
How personal loans work
When you sign up for a personal loan, you agree to borrow a sum of money and repay it over a predetermined term. The most common terms range from one to five years, but some lenders offer longer terms. In most cases, your interest rate and monthly payment are fixed and won’t change during the loan term. This makes budgeting easier.
Suppose you borrow $20,000 to consolidate high-interest credit card debt and you have excellent credit. In that case, your lender may offer you a five-year repayment and an Annual Percentage Rate (APR) as low as 6.5%.
The AmOne Installment Loan Calculator shows that you’d be paying $391.32 per month for five years, and your credit card debt will be gone. Try the calculator now. See what your monthly payment would be for loans with different amounts, terms and interest rates.
If your loan amount is higher than $35,000 to $40,000, and / or you want a repayment term that exceeds five years, you need to make that clear when shopping for a loan. Not all lenders offer those terms, but many do.
One big benefit of personal loans is the fact you can shop, apply and receive your money without ever leaving your home. Many online loan websites also let you compare multiple personal loan offers in one place, saving you both time and money in the end.
Best uses for personal loans
There is no one “right way” to use a personal loan. Whether it’s the right way for you to meet a financial need depends on you. Your resources. Your credit rating and income. And why you’re borrowing.
Still, there are plenty of common uses for personal loans. Here’s how they work.
Debt consolidation is a popular use for personal loans. Once reason is that, according to the Federal Reserve, the “spread” between personal loan interest rates and credit card interest rates is higher than it’s been in 20 years. So you may be able to nail down a lower interest rate — and that rate, unlike credit card rates, is likely to be fixed.
Consolidating debt with a personal loan can even improve your credit score. By reducing credit card balances, you’ll drop your “utilization ratio,” the percentage of your credit card limits you use. Utilization makes up 30% of your FICO score. You normally want to keep utilization below 30%.
Consolidating credit cards with a personal loan zeros your utilization ratio.
Wedding experts at TheKnot.com report that the average cost of a wedding was $33,931 last year. This figure includes the cost of a venue, the dress, food, entertainment, and more. One issue many face when planning a wedding is that much of the cost must be paid upfront. Sometimes up to a year in advance.
That’s why many people turn to personal loans to fund wedding expenses. You have the option to borrow money now with a fixed interest rate then repay it back over time. Ideally, you’ll have the loan paid off before the wedding. Or at least be able to clear your balance with cash wedding gifts.
Home improvement projects
Home improvement is another popular use for personal loans. While home equity financing is often the cheapest option for the largest projects, it’s not always appropriate. You can’t get it if your home is listed for sale. Or if you don’t have enough home equity. The costs like title insurance and appraisal fees might be a large percentage of the loan if you don’t need more than a few thousand dollars. And it’s harder to borrow against investment properties and vacation homes.
But you can use a personal loan for almost anything, and the process is fast. No waiting for an appraisal. Interest rates, especially if you have good credit, are fairly competitive with home equity financing.
Pay for a major purchase
Many consumers put major purchases on credit credit cards because it’s convenient. or because they get cash back or other rewards. While credit cards might be the best way to buy a big-ticket item, they’re not usually the best way to finance a large purchase. Interest rates are relatively high and they can increase.
In addition, credit card use can damage your credit score. If you have a $10,000 credit limit and use $1,000, that’s good. If you carry more than $3,000, that’s bad for your utilization ratio and your FICO score.
So, if you can’t pay off your purchase within the next billing cycle, consider a personal loan to protect your credit score and save you money.
Medical providers frequently demand payment upfront for non-emergency procedures. A personal loan can be the best financial arrangement for such costs. Especially because you can get one without leaving home — a consideration if you’re not felling well.
You can also use a personal loan for optional procedures not covered by insurance, such as medical tourism and cosmetic surgery.
Moving can be expensive. In fact, the average out-of-state move costs $4,300. You may have to move when it’s financially difficult. For example, you may be switching jobs or dealing with a family emergency.
Moving loans make sense when they are your lowest-cost option, when you’re moving a longer distance (enlisting your friends and buying a pizza won’t cover it), and you need to move right away. You don’t have time to save up for the experience.
If you’re moving for a new job and the employer covers the cost, you might still have to come out-of-pocket and wait for reimbursement. In that case, a personal loan can get you where you need to be as soon as possible.
Personal loan fees
Speaking of fees, it’s important to understand that many personal lenders don’t charge any fees for their personal loans. The best loan for you offers the lowest cost combination of fees and interest rate.
Personal loans with no fees and the best interest rates tend to go to consumers with great credit. If your FICO score is lower than 740, you may have to pay fees.
Loan fees don’t have to be a deal-breaker, however. Here’s a list of common fees. But it doesn’t matter what they are called. It’s the bottom line cost of fees and total interest that should concern you.
- Origination fees: This is the charge for processing and funding your loan. It can range from 0% to 8%
- Prepayment penalties: This fee only applies if you repay the loan early — before the end of the term. It may be a percentage of the loan amount or several months of interest
- Application fees: Most lenders don’t charge application fees. You may have to pay for a credit report, but avoid application fees
- Late payment fees: This fee only applies if you pay your monthly payment after your due date
Just remember that the total cost is what’s important. the worksheet below shows two examples of personal loans with different interest rates and fees:
How to qualify for a personal loan
Exact requirements for personal loans vary among lenders. Some specialize in credit-challenged applicants. Others prefer only highly-qualified borrowers. The better your package, the more choices you’ll have.
Minimum credit scores for personal loans range from 500 to 740. Interest rates range from under 6% to over 36% and depend mostly on your credit score. Loans advertised as ‘personal loans with no credit check” are fakes. They are really payday loans, check advance loans or title loans. Avoid them.
You need proof of your income for a personal loan. Loans that don’t require proof of income might be called personal loans, but they’re not. They are title loans or check advance loans disguised as personal loans. Stay away.
You can typically prove your income with pay stubs or tax returns. Your personal loan approval depends on having a stable and sufficient income.
Lenders consider the relationship between your income and other debts when deciding how much to loan you. Personal loan companies set maximum debt-to-income (DTI) ratios between 36% and 50%.
What’ s a DTI? It’s your debts, including rent or mortgage, plus the minimum monthly payments on your other accounts like auto loans, student loans and credit cards, divided by your gross (before tax) monthly income. Living expenses like food and utilities don’t count.
If your income is $4,000 a month your rent is $1,000 and you have no other debts, your DTI is 25%. that’s $1,000 / $4,000. If you wanted to borrow $10,000 at 8%, your payment would be about $203. So your debts would be $1,203 and your DTI would increase to just over 30%.
You may need a co-signer
If your credit isn’t that great, or your income is insufficient or unstable, you may need a co-signer. The co-signer is responsible for repaying the loan if you don’t do it. In addition, if you make a payment late, you could damages your co-signer’s credit. Your late payment will probably show up on their credit report.
Don’t ask anyone to co-sign for you if you have any doubts about being able to repay the loan responsibly.
Pros and cons of personal loans
Personal loans have their advantages and drawbacks. They are the best choice for many consumers and circumstances. But always the cheapest or most appropriate financing available for others.
Personal loan advantages
Fixed interest rates
Fixed interest rates and unchanging payments make budgeting easier.
Personal loan terms mostly range from one to five years (some go up to 10). The faster you repay your debt, the less interest you will pay.
It’s no secret that revolving accounts like credit cards can take decades to pay off. With a personal loan, there is a definite term. Make your payments and know exactly when your loan will end.
Borrow a lump sum for any reason
Many loans are for a single purpose. You get a mortgage to buy a home and the lender must appraise the home. or you may have to spend the money on a car, home improvement or medical procedure. Personal loans are private and you needn’t disclose your reason for getting one.
Lower interest rates
Typical personal loan interest rates are lower than credit card rates for similar borrowers. And those rates are usually fixed.
You don’t put up collateral for a personal loan. So if you default, the lender can;t take your house, car, boat or whatever. You can discharge a personal loan in a bankruptcy proceeding.
A personal loan could help your credit score
Paying a personal loan on time creates positive credit history and can improve your FICO score. And replacing credit card balances with a personal loan can reduce your credit utilization. Utilization is your credit card limits divided by your credit card balances and affects 30% of your FICO score.
Personal loan drawbacks
You’re still borrowing money
Personal loans are still loans you have to repay. if you use a personal loan to consolidate credit cards, you run the risk of harming your financial health if you can’t stop yourself from running up balances again.
Your payments may be high
Personal loan repayment terms are shorter than those of mortgages. And you can’t use them indefinitely like you can a credit card. That’s great for minimizing your interest expense, but can cause payments to be higher. Make sure you can afford the payment when you choose a personal loan.
They’re not free
Lenders don’t work for free. They may charge upfront fees to originate your loan. Consider the fees and interest rate when choosing a personal loan.
Failure to repay can be costly
Just because the loan is unsecured doesn’t mean a lender can’t pursue repayment. It can take you to court and get a judgment. It can report your late and missed payments to credit bureaus. You may be worse off after taking a personal loan if you don’t pay it on time each month.
How to apply for a personal loan
If you’re ready to commit to a personal loan, you’ll be happy to know that the application process is usually fast and easy. You can do the whole thing online if you prefer, and it’s even possible to have your loan funded online without ever visiting a bank. Here are some steps you should take to find and apply for the best personal loan for your needs:
Step 1: Check your credit score
It can help to know where you stand in terms of your credit score before you apply for a personal loan. You’re entitled to a free copy of your report every year from each of the major bureaus — Experian, Equifax and TransUnion. You can obtain your scores as well for a nominal fee. The government’s site, www.annualcreditreport.com, is the only non-commercial site that won’t charge you fees or sell your information.
Step 2: Compare loan companies online
It can also help to compare loan companies and their specific offerings online. Look for a lender that offers loan amounts high enough to meet your needs, low interest rates for consumers with credit scores in your range, and low loan fees.
Step 3: Get preapproved without a hard inquiry on your credit report
Once you’ve checked out several lenders, give precedence to online loan companies that let you get preapproved for a personal loan without a hard inquiry on your credit report. Getting a pre-approval can help you gauge how much you might be able to borrow as well as the interest rate you’ll ultimately pay.
Step 4: Play around with a loan calculator
Once you can estimate your interest rate, play around with a loan calculator. This step can help you determine what kind of monthly payment you’ll end up with once you choose a loan amount and repayment term.
Step 5: Receive loan funding in as little as 2-3 business days
Once you’re preapproved for a loan that suits your needs, complete the formal loan application online. Your final approval may take just a few minutes or a few business days, depending on the lender you and program you choose. You may get your funds as soon as the next business day.
Alternatives to personal loans
Personal loans are often the best way to finance a purchase of goods or services, or to consolidate debt. But no product is right for all people or all uses.
Credit cards offer convenience. Most of us have a few in our wallets. Unlike personal loans, many credit cards offer cash-back or travel rewards for each dollar you spend. Highly-qualified applicants may qualify for perks like 0% interest rates or airline miles.
However, while credit cards might be a great way to make purchases, they can be expensive to finance purchases. Interest rates average about 17%, while personal loan interest rates, according to the Federal Reserve, average about 10%.
Credit cards can also make spending too convenient, which is why so many people who use credit cards excessively can end up in financial trouble. Studies show that you are far more likely to make an impulse purchase when you use a card than when you carry cash.
Peer-to-peer (P2P) lenders
You may want to consider peer-to-peer lenders in addition to traditional companies that offer personal loans. While the original P2P model involved individuals lending to each other, that’s no longer true. Large institutions fund many of these loans. But the competition from individuals keeps rates down.
Loans from peer-to-peer lenders work similarly to traditional personal loans. And guidelines tend to be conservative. However, there are lenders specializing in lower credit tiers, so consider these sources when shopping for unsecured financing.
Home equity loan
Homeowners with equity may want to consider borrowing against it to meet a need for cash. Like personal loans, most home equity loans come with fixed interest rates, fixed repayment timelines, and fixed monthly payments. This makes them easy to plan for and budget for — especially if you hate surprises.
Because the repayment period is long (usually ranging from 10 to 30 years), the payments can be quite low. And because your home secures the loan, it’s less risky for the lender and your interest rate should be quite low.
The downside is that even with a low interest rate, your total interest expense can get very high if you stretch out your repayment for decades. Upfront costs like appraisals and title insurance can be high compared to the amount you borrow. And your home is on the line if you can’t make your payments. Finally, because it involves real estate, a home equity loan creates a public record showing how much you borrowed and who you owe. Not everyone likes that.
In general, home equity financing is best for larger amounts.
Home equity line of credit (HELOC)
Home equity lines of credit, or HELOCs, also require you to borrow against the equity in your home. They are generally have lower setup costs than home equity loans, are very flexible, and offer lower interest rates than personal loans. However, they almost always carry variable interest rates. Your home is on the line if you can’t repay.
And HELOCs have another feature that can cause problems. You only get to tap the credit line during the early years of the loan, and your minimum payment is just the interest on whatever you borrow. Your payment may be very low — for example, a $20,000 balance at 5% has a payment of just $83 a month. But then you enter the repayment phase. No more borrowing, and you have only the remaining loan term in which to pay it back.
So if you take a 15-year HELOC with a 5-year drawing period, the payment on your $20,000 balance (assuming that your 5% rate doesn’t increase) goes to $212.13. Be prepared for this to avoid financial problems.
Borrow from friends or family
Finally, don’t forget that you may be able to borrow the funds you need from family or friends. You may even be able to do so at a low interest rate (or even for free). But don’t ever put a relationship on the line over money.
You probably shouldn’t choose this option if you can’t qualify for a loan from other sources. That’s because trained lenders have determined that your finances are not healthy enough to sustain a loan repayment. Your family might not know this, and you might not know this either unless you’re a loan professional.
If you just want a better deal, and your family or friends are willing, or you have positive information that lenders aren’t allowed to consider (for instance, you’re expecting a windfall gift, inheritance or settlement), this may be a good option.
Personal Loans Frequently Asked Questions (FAQ)
Can I get a personal loan if I have a low credit score?
There are personal loan sources that specialize in lending to consumers with fair or bad credit scores. You may have to borrow less than you want because debt-to-income guidelines may be more strict. Expect to pay higher interest rates and fees. It’s important to shop among competing lenders, however. No need to pay more than necessary just because your credit score is low.
You might qualify for a better loan if your low score is not due to bad credit history. If your problem is a short credit history, or “thin file,” you may not have a problem getting a decent deal.
What information do I need to apply for a personal loan?
“How to apply for a personal loan?” is a normal question. The answer is, it’s easy. Lenders want information needed to pull a credit report (name, address, social security number, etc.). You must prove your income with a pay stub and / or tax return unless your lender can pull it directly from your employer’s payroll processor. You may also need to supply copies of bank statements or authorize the lender to verify your accounts with your bank.
Can I use a personal loan to get out of debt?
Debt consolidation is one of the most popular reasons consumers take out personal loans. Consolidating higher-interest debt can help you save money and get out of debt faster.
Understand, however, that your payment may go up even if your interest rate drops. That’s because credit card companies let you make small minimum payments that keep you in debt for decades. Personal loans require higher payments because your loan will be cleared at the end of its term. This can range between one and 10 years, with two-to-five years being the most common.
Also, be very careful about running up your credit balances after clearing them with a personal loan. If you tend to carry balances, credit counseling and debt management may be better choices for you.
Can I pay my personal loan off early?
You can always repay a loan early. However, some personal loans do come with prepayment penalties that add to your costs if you pay them off early. If this is an issue for you, don’t accept an offer for a loan with a prepayment penalty. There are plenty of options without them.
Why might you choose a loan with a prepayment penalty? If the interest rate is lower and you don’t expect to pay it off before the end of its term.
Can I use personal loan funds for any purpose?
One big benefit of personal loans is the fact you can borrow for any reason and use your funds however you want. You may be asked to list the reason for your loan on your application, but the bank will not follow up to see how you spent the money.
What will my monthly payment be?
Your monthly payment depends on how much you borrow, your interest rate, and the loan repayment timeline you choose. If you’re curious how much you may need to pay for your loan on a monthly basis, a personal loan calculator can help you get a good idea.