How Do Personal Loans Work?

A personal loan is a lump sum of money up to a certain amount from a lender. You agree to pay it back, with interest over a set term.

Most personal loans are unsecured, which means that you don't have to put up any collateral like your house or your car.

Key Takeaways

• Personal loans give you a lump sum you pay back in fixed monthly installments with interest, usually over two to seven years. Most are unsecured, so you don't need to put up collateral, such as your home with a mortgage, or a car with an auto loan.

• Your interest rate depends on your credit, the amount you borrow and the loan term. Your annual percentage rate (APR) includes that rate and some lender fees, to give you an overall cost. Missed payments can trigger late fees, hurt your credit score and even send your account to collections if it continues.

• Before you apply, get prequalified with a few lenders to compare rates, confirm the monthly payment fits your budget and check the agreement for prepayment penalties.

Summary generated by AI, verified by MoneyLion editors

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How Do Personal Loans Work for Borrowers and Lenders?

A personal loan involves two parties: the borrower and the lender. Here's how it works for each of them.

For borrowers:

• The goal: Obtain funds quickly and affordably

• Risks involved: Potential for high interest and fees if payments are missed

Here's how the process works:

1. You apply for a specific amount of money to be repaid over a specific period of time at a specific rate of interest.

2. When approved, the bank gives you a lump sum.

3. You make monthly payments, which consist of principal and interest.

4. Use the money for whatever you want.

5. If you miss payments or make them late, your credit may be affected, and you can be charged late fees.

For lenders:

• The goal: Earn interest.

• Risks involved: The borrower may not repay and potentially default on the personal loan.

Here's a general idea of how the loan application works on the lender's side.

1. Lenders assess the applicant's creditworthiness to determine if they want to lend to them, and at what interest rate.

2. Lenders give the borrower a lump sum of money when the loan is approved.

3. The lender collects the payments each month. The interest is their profit on the loan.

4. If the borrower defaults, the lender could lose the money.

How Does Taking Out a Loan Work?

Here are the steps to take to get a personal loan.

1. Get prequalified.

2. Research lenders to find the best rate.

3. Apply for the loan, providing personal information and proof of your income.

4. Agree to a credit check.

5. Get approved by the lender and sign the loan agreement.

6. Receive the money in a lump sum.

7. Make monthly payments as agreed until the loan is paid off.

How Does Interest Work on a Personal Loan?

Interest works on personal loans as the cost lenders charge you to borrow money, typically through an annual percentage rate (APR).

For a personal loan, the interest is calculated based on:

• Interest rate

• Amount borrowed

• Length or term of the loan

When a lender loans money, they charge interest — this is their profit for lending the funds.

Is a Personal Loan Right for You?

A personal loan is a good choice for you if:

• Need a lump sum fast

• Have good or excellent credit

• Can make the monthly payments

You shouldn't take out a personal loan if you:

• Can pay cash or qualify for cheaper financing

• Can't afford the monthly payments

• Don't have a clear need for the funds

How Personal Loans Can Help You Move Forward

Once you know how a personal loan works, you'll have a better chance of getting ahead on your finances, control your debt and make life easier to manage.

You can use a personal loan to consolidate debt, cover an emergency or for a major purchase. When personal loans are used wisely, they can be an incredible tool to improve your financial situation and meet your goals.

FAQs 

Can I get a personal loan with bad credit?

Yes, you often can get a personal with bad credit, but your interest rate will likely be high. If you decide to apply, make sure you understand how much you'll pay each month, and be sure it fits into your budget.

How long does approval take?

Getting approved for a personal loan can take as little as a day or two, or up to a week or more, depending on the lender.

Will a personal loan hurt my credit score?

Sometimes, yes, your credit score may take an initial hit when you apply for a personal loan. You may also see a decline in your score when you get the loan, as your credit utilization may go up. As you pay fthe loan on time, your score should bounce back again.

Can I pay off the loan early without a penalty?

Yes, often you can pay off a loan early without a penalty, but this depends on the particular loan. Be sure to check your loan documents carefully before you sign so you aren't hit with a prepayment penalty.

What happens if I miss a payment?

If you miss a payment, you may be charged a late fee. If you miss more than one or two, your loan may go to a collection agency. Your credit score will be negatively affected if either of these things happen.

Key Terms

• Personal loan: A personal loan is a lump sum borrowed from a lender that you pay back in fixed monthly installments with interest over a set term, typically two to seven years.

• Unsecured loan: An unsecured loan is a type of loan that doesn't require collateral like a house or car. Approval depends on your creditworthiness rather than an asset the lender can seize.

• Annual percentage rate (APR): The APR is the yearly cost of borrowing money, shown as a percentage. It includes the interest rate and some lender fees, making it useful for comparing loan offers.

• Principal: The principal is the original amount of money you borrow, not counting interest or fees. Each monthly payment goes toward reducing the principal and covering interest. You can usually make extra payments to go toward the principal.

• Prepayment penalty: A prepayment penalty is a fee some lenders charge if you pay off your loan early. Always check your loan agreement before signing to see if one applies.

Sources

• Consumer Financial Protection Bureau: consumerfinance.gov/ask-cfpb/what-is-a-personal-installment-loan

• Consumer Financial Protection Bureau: consumerfinance.gov/ask-cfpb/what-is-the-difference-between-a-secured-and-unsecured-loan

• Consumer Financial Protection Bureau: consumerfinance.gov/ask-cfpb/what-is-the-difference-between-a-loans-interest-rate-and-the-apr

• Federal Trade Commission: consumer.ftc.gov/articles/personal-loans

• Merriam-Webster Dictionary: merriam-webster.com/dictionary/principal