How Do Personal Loans Work?

Personal loans are incredibly versatile, and millions of Americans turn to personal loans every year. To meet the demand, the online lending industry has exploded in recent years. But how do personal loans work?

Personal loans work like other installment loans, which are issued as a one-time payment to borrowers. Loan amounts range from as little as $500 to as much as $100,000. The borrower repays the loan plus interest on a monthly payment frequency throughout the lifetime of the loan. 

If you’re looking for or considering a personal loan and what to know more about the process, read on. This article will explain everything you need to know before you apply. 

Types of Personal Loans

Not all personal loans are the same. The two kinds of personal loans include secured and unsecured. Each has its own pros and cons, but one may be a better option for you than the other.

Secured Personal Loan

A secured personal loan requires collateral, which benefits the lender because it lowers their risk if the borrower defaults on the loan. It also benefits the borrower, because it results in increased chances for approval and smaller interest rates. 

The downside of a secured loan is that the collateral can be repossessed if the loan is not paid.

Unsecured Personal Loan

An unsecured personal loan doesn’t require collateral, thus eliminating the chance of repossession. However, the chance of approval is more difficult, and the lender will closely review your credit profile, income, and debt.

You may also face higher interest rates.

Shopping Around for a Personal Loan

There’s no shortage of available lenders, as the internet is saturated with lenders. Therefore, you have the benefit of shopping around to find the best rate for you. 

You also have the opportunity to review qualifications to increase your likelihood of approval. 

Lender Marketplaces

If you’d rather not tackle lender research, there are other options, namely, lender marketplaces. A lender marketplace is a service that shops around for the best personal loan offers for you. 

Popular services of this nature include the following:

• Credible
• SoFi
• LendingTree
• Upstart

While there’s an abundance of online lenders, that isn’t to discredit traditional banks and credit unions. Particularly if you have an existing or prior relationship with a financial institution, they may still be a solid option as you seek a lender. 

At banks and credit unions, personal loans may be marketed as home improvement loans, debt consolidation loans, or something similar.

Personal Loan Application

After selecting a lender for your personal loan, if you’re comfortable with the interest rate and the terms, your next step is to apply. The applications are relatively simple and short. 

Here are the things you need to do:

• Identify your borrowing needs and repayment ability. Determine how much you need to borrow and how long it’ll take you to repay it. 
• Review your credit. Keep in mind that approval isn’t guaranteed and is based on your credit profile and worthiness. 
• Have required documentation. Typically, you’ll be asked for identifying information, including your date of birth and social security number. You’ll also need to provide employment information and income, as well as proof of your income. 

How Personal Loans Are Constructed

A personal loan has three main components, which include fixed interest rates, fixed terms, and fixed payments. One reason that people choose personal loans is that the terms are straightforward. 

Here are the details of the main components of a personal loan:

• Fixed interest rates: Fixed interest rates are guaranteed for the life of the loan.
• Fixed terms: A loan’s term refers to the length of the loan. Most personal loans have three to five-year terms.
• Fixed payments: Fixed interest and fixed terms result in fixed payments. The payments remain the same over the lifetime of the loan.

Fees & Charges

While many people naturally anticipate interest rates for their personal loans, they may not expect any other fees. Any charges or fees beyond interest rates vary widely and are determined by the lender. 

Below are charges and fees that may be assessed:

• Interest: It should be considered that rates vary significantly. Two factors directly impact your interest rate, which include your credit score and the length of your loan. 
• Origination fee: An origination fee is a fee that’s charged to cover the cost of processing the loan, which falls between 1% and 6%, typically. The origination fee is sometimes referred to as an administrative fee. 
• Prepayment penalty: Paying a loan off early serves the borrower well, as it saves on interest paid overall. Conversely, it means the lender loses money when a loan is paid in full early, which is why some lenders charge a prepayment penalty to offset the loss.

Approval Timeline

The application decision time frame varies.  Some approvals arrive in less than an hour while others can take up to five business days.

Although it varies by lender, it also depends on how quickly the required documents are submitted and if the application was submitted during business hours.

Fund Disbursement

If you need a personal loan for an unexpected expense, you may be wondering how quickly the funds will make it to you. Fortunately, most funds are delivered quickly via electronic wire transfer to your bank account.

Another option, though much slower, is a paper check. 

Reasons for Personal Loans

According to TransUnion, personal loans are used more and more in recent years. People gravitate towards personal loans because they can be used for many purposes.

The most common reasons for personal loans are:

• Debt consolidation
• Unexpected expenses
• Home improvements
• Starting a business
• Pay medical bills

Personal Loan Alternative

Depending on the reason you need the loan, there may be another option that better meets your needs. That might be a balance transfer credit card with a 0% introductory APR.

This is a good option if the need for a personal loan is for a purchase. Once the purchase is made and the balance is on the 0% APR credit card, you can make payments during the introductory period without accruing interest. 

However, you must remember the terms of the introductory offer. If the balance isn’t paid in full by the end of the 0% introductory period, you’ll be charged interest, which could be a significant amount.

Conclusion

A personal loan is an installment loan that can be used for a myriad of reasons. It has a fixed interest rate and a fixed term, so your monthly payments remain the same with no fluctuation.

Personal loans are easy to apply to, and there are plenty of lenders to choose from.