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How Personal Loans Work

Finance | 09/22/2023 20:58

When we think of loans we tend to think of them as tied to a specific thing. For instance you may take out an auto loan to purchase a car or a mortgage to purchase a house. But there is a more general loan that is available to you if you need cash for a different reason: a personal loan. Personal loans can help consolidate debt, make a large purchase, or help cover a life event such as a wedding. While personal loans are not always a good idea, there are many instances when a personal loan can be useful and may be worthwhile.

Let’s talk about how personal loans work.

What is a personal loan?

A personal loan is a type of loan that can be used for nearly anything. They have a set repayment period and interest rate and you will be responsible for making a payment every month to the lender that loaned you the money. The amounts, interest rates, and repayment period can vary dramatically depending on the lender and the applicant. 


A personal loan could be as small as $1,000 but can easily stretch to $100,000. The interest rate will depend on the type of loan it is and can range from 6% to over 30%. Repayment periods can be as short as one year or stretch to seven years.

Are there different types of personal loans?

Personal loans can all be used with very few restrictions, but there are differences in loan types that you should understand. Loans are divided into two categories, unsecured loans and secured loans. An unsecured loan means that there is no collateral. You can simply sign the loan agreement, get a lump sum of money, and make your payments as they are outlined in your contract. Personal loans are unsecured for the most part. Secured loans mean that collateral is required to receive the money. This means that if you fall behind on payments or your account becomes delinquent, the bank can take your collateral as payment. Auto loans and mortgages are both secured loans because the bank can take your car and house, respectively, as payment if you fall behind.


There is another type of personal loan called a credit builder loan that you may qualify for if you are unable to get approved for a regular personal loan. Instead of extending a line of credit for you to pay back, you make payments into an account. The lender will report this to the credit bureaus, allowing you to build your credit. When you pay the full amount, the money is released to you, minus fees.

How are interest rates calculated?

The interest rate that is offered on personal loans can vary widely. Lenders will consider the following when determining the interest rate for your personal loan:

  • Your credit score

  • Your income

  • Your debt-to-income ratio

  • The prime rate, set by the Fed

  • Your employment history

  • The amount of the loan

  • The repayment period of the loan

Your finances are the biggest factor when it comes to what interest rate you will be offered. Those with the best credit scores and lowest debt-to-income ratios will be offered the best interest rates. A shorter repayment period will also earn you a lower interest rate.

What can I use a personal loan for?

There are no real restrictions on what you can use a personal loan to buy. Here are some common reasons people get personal loans.


An emergency

Sometimes things happen that catch us unprepared and without the necessary cash. A surprise visit to the hospital can leave you owing hundreds of thousands of dollars. A burst pipe in your home may cause damage that insurance doesn’t cover. The death of a loved one may lead to unexpected funeral expenses. A personal loan can help you cover these costs and pay them back over time.


Debt consolidation

If you have several loans with high interest rates that are causing you trouble, a personal loan can help you consolidate. Instead of tracking five or ten accounts you can pay them off with your personal loan and focus all of your payments and energy on one account.


An event or holiday

Sometimes we cannot wait until everything is perfect to take that big trip or make that big leap. Maybe you got a great opportunity to take a trip and need some cash, or maybe it’s finally time to walk down the aisle at your wedding. Either way a personal loan can help you afford it.


A home improvement project

Another common reason for a personal loan is to make an expensive home improvement. A new roof, remodeled kitchen, or an addition can all cost big bucks these days. It may be hard to save that much money, and maybe you simply cannot afford to wait that long. A personal loan can help you make the improvements you need when you need to make them.


Is a personal loan better than a credit card?

But wait–if you have a credit card with a high limit, why would a personal loan make sense? In general a personal loan will have a better interest rate than your credit card. And more than that, personal loans have fixed interest rates while credit cards have variable rates. This means that at any point your credit card company can increase your interest rate. If you take out a personal loan with a fixed rate you are guaranteed to keep that interest rate for the life of the loan. That doesn’t mean that you should always run to get a personal loan when you need to make a purchase, but it’s a good idea to do some research. If you know that you can pay it back quickly it may make more sense to buy something on your credit card rather than going to the trouble of taking out a personal loan.



How do I apply for a personal loan?

Determine how much you need. 

You obviously want to get a loan that is large enough to cover what you need, but you want to avoid overborrowing. If the loan is too large you may have trouble paying it back, which can cause major trouble down the road and could ruin your credit score.


Prepare ahead of time.

Prepare for a personal loan application the same way you would prepare for any loan application. Request a copy of your credit report to review for any errors and make sure everything is accurate. If you need a personal loan for an emergency there may not be time to get your finances in order per se, but knowing how your credit report looks will help you determine where you might be able to get a loan.


Try to prequalify.

You should always try to prequalify for a loan ahead of time, as this will save you a lot of time. This will allow you to weed out lenders that won’t give you a personal loan, rather than going through the entire application process with each and every lender. Not all lenders offer pre qualifications, so you may have to fill out actual applications for some loans with no real idea whether or not you will qualify. But preliminary research will hopefully help you determine if you qualify. After you prequalify with a few different lenders you can move onto the application process.



The application process will differ from lender to lender but you will typically need the following to apply:

  • Driver’s license or other government issued photo identification

  • Proof of residence

  • Recent pay stubs or recent tax returns

  • Banking information


The lenders will request access to your credit report which will count as a hard inquiry on your report. You want to be sure to apply to all of your lenders at the same time so that all hits will count as one hard inquiry (the credit bureaus give you a fourteen day window where all requests can be lumped together as one hit).


Get approved and receive your money.

After you are approved and sign all of the documents, you can then receive the money for your personal loan. The time of this will vary from lender to lender, but you will usually have your money deposited to you as one lump sum of cash within a few days. Some lenders can even complete this on the same day.


Pay your loan back.

It’s incredibly important to make regular, on time payments to your lender. Missing payments can trigger fees and cause damage to your credit score that is hard to come back from. 

That’s everything you need to know about personal loans.


Personal loans can be very useful for many people. Whether it’s an emergency that hits your wallet hard or an opportunity that you can’t pass up, sometimes you just need cash fast. 


If you need cash and have a car loan, refinancing can help free up some money for you. Contact Auto Approve today to find out home much money you could be saving!



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