How Personal Loans Work

Some people are quick to dismiss personal loans as a financing option because they associate this kind of borrowing with buying a big item. But personal loans are highly adaptable — the Jack of all trades, in fact. They can be used for debt consolidation, paying emergency bills, taking a well-deserved holiday and much more.

Understanding how a personal loan works can potentially save you money too, as it can be cheaper than using a credit card depending on your situation.

[ Read: Is a Personal Loan My Best Option? ]

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In this article

    What is a personal loan?

    A personal loan is a borrowing agreement where a financial institution lends you money for a specified purpose. You’ll have to repay this of course, with interest, over an agreed term.

    Personal loans backed by collateral are called secured loans. If you take out this type of loan and fail to pay up, then the lender can seize the collateralized asset to settle the debt.

    Personal loans not backed by an asset are called unsecured loans. Because lenders are exposed to a greater risk of losing money, they tend to charge higher interest rates for this type of lending.

    Traditional lenders for personal loans include banks, credit unions and consumer finance companies. Online and peer-to-peer lenders have also gained popularity in recent years.

    [ Read: Secured Personal Loans vs. Unsecured Personal Loans ]

    How a personal loan works

    While the application, approval and funds distribution processes may differ among lenders, the crux of how personal loan works remains the same.

    Once your loan application has been approved, funds will be disbursed into your nominated bank account.

    Your monthly repayments are determined by the interest rate, loan duration and the loan size. In terms of interest rate, this can be fixed or variable — but are typically fixed. Loan terms are usually between 12 and 84 months while the amount can be anything from $1,000 to $100,000.

    However, bear in mind that there may be additional charges such as origination fee, late fees, application fee and prepayment penalties.

    Interest rates and APRs

    As interest rates and APRs reflect the cost of borrowing, they are key considerations when evaluating a loan.

    Interest rate refers to the cost you will pay to borrow money expressed as a percentage. Put simply, if you borrow $1,000 at an interest rate of 6%, then you’ll have to repay the principal of $1,000 plus $60 in interest.

    Annual percentage rate, or APR, reflects the loan interest rate as well as associated fees and charges. It provides a more accurate picture of how much the loan costs. However, bear in mind that APR comparisons may not be useful if you’re looking at inherently different products — say a variable-rate loan and a fixed-rate loan.

    In a fixed-rate loan, interest rate remains the same throughout the life of the loan. However, interest can be adjusted either up or down in a variable-rate loan.

    Each lender will have its own criteria for determining the interest rate applicable to a loan, but many will look at your credit score, credit history, the size and regularity of your income, employment status, asset and debt levels as well as the amount of debt you have relative to the credit available to you (known as credit utilization ratio).

    [ Read: How to Get a Loan With Bad Credit ]

    How to apply for a personal loan

    1. Understand your borrowing needs. Figure out how much you’ll need to borrow and what you can afford to repay monthly. This will help you choose a loan term. Consider whether you would like a fixed or variable rate loan.
    2. Check your credit report. Be sure to fix any inaccuracies.
    3. Shop online. Compare personal loans from different lenders. Remember to check for fees and penalties. If your credit isn’t great, some lenders cater specifically to people with bad credit.
    4. Sort out paperwork. Once you have identified potential loans of interest, start gathering documents such as your Social Security number, salary and employer information and details of your assets and debts.
    5. Prequalification. Many lenders offer prequalification using a soft credit pull to give you an idea of the rate and terms you might expect. You’ll need to answer some simple questions using the paperwork in step four.
    6. Make a full application. If the pre-qualification terms are acceptable to you, make a full application to find out your exact loan terms.

    When to get a personal loan

    A personal loan is worth considering if you know how much you need to borrow and you need time to pay it off. You should ideally have a stable source of income and feel comfortable that monthly repayments won’t put a strain on your cash flow. Although personal loans can be used for almost anything, they are particularly handy in the following scenarios.

    • Debt consolidation. You can potentially consolidate debts at a lower interest rate to save on interest charges.
    • Emergencies. Unexpected car repairs or medical bills can be mitigated with an emergency personal loan.
    • Home improvement. Since taking out a home equity loan exposes you to the risk of losing your property if you fail to repay, a personal loan is a safer option for renovation projects.

    [ Read: Has the Pandemic Made It Easier to Get a Personal Loan? ]

    Things to consider about getting a personal loan

    Although starting APRs for personal loans can appear highly attractive, the best rates are often reserved for individuals with strong credit. If your credit needs work, then you’ll likely be offered a higher APR. 

    However, even if your credit is excellent, it’s still worth exploring whether there are cheaper alternatives. For example, if you can qualify for a balance transfer credit card with a 0% intro APR offer for 18 months, then your cost of borrowing could be as little as the balance transfer fee, provided you can pay off the balance before the intro period finishes.

    It’s worth bearing in mind that lender’s fees can make personal loans more expensive than other products.

    Is a personal loan right for you?

    How can you tell if a personal loan is right for you?

    Personal loans could be ideal if you’re after a flexible financing tool to buy or pay for something you haven’t saved up for. They’re also great if you’re looking to reduce interest charges on mounting credit card debt. However, you’ll have to make regular repayments, so they’re best suited to someone with stable income.

    [ Related: The Pros and Cons of a Personal Loan ]

    While a personal loan’s flexibility means you can borrow what you need over a loan term with affordable repayments, keep in mind lower monthly repayments result in borrowing for a longer period — and therefore paying higher interest overall.

    We welcome your feedback on this article. Contact us at with comments or questions.

    Kristie Kwok

    Contributing Writer

    Kristie Kwok is a finance content writer with in-depth knowledge of the banking industry from her previous work experience in banks such as UBS, Lloyds Banking Group and Royal Bank of Scotland. She is a qualified accountant with a Bachelor of Commerce degree, specializing in Accounting and Finance.