How Does a Personal Loan Work?

by

If you’ve been wondering, “How does a personal loan work?” you’re definitely not alone. Personal loans might seem straightforward on the surface — you borrow money, you pay it back — but there’s a lot more happening behind the scenes that can either save you money or cost you big time. 

How does a personal loan work differently from just putting everything on a credit card? Why do people rave about them for debt consolidation? And more importantly, what’s the catch?

Let’s ditch the confusing financial jargon and walk through exactly how personal loans work, step by step. By the end of this guide, you’ll know whether a personal loan makes sense for your situation and how to use one to your advantage.

Table Of Contents:

So What Is a Personal Loan?

A personal loan is pretty straightforward. You borrow a specific amount of money from a lender in one lump sum. Then, you pay it back over a set period with fixed monthly payments.

This is very different from a credit card, which offers a line of credit you can use and pay back repeatedly. This is called revolving credit, and its interest rates are often quite high.

Personal loans are a form of installment credit, meaning you get the money once and have a clear end date for your payments, improving your personal finance health.

Many people use personal loans to pay off all their credit cards. This leaves them with just one monthly payment to manage, often at a lower interest rate.

The Personal Loan Process Step by Step

Most lenders have a clear process for personal loans.

Here’s what you can generally expect:

  1. Pre-qualification: This is like a test run. You give an online lender some basic financial information, and they tell you what loan amounts and rates you might qualify for. This step usually involves a soft credit check, which won’t hurt your credit score.
  2. The Application: Once you pick from multiple lenders, you’ll fill out a formal loan application. You’ll need to give details like your income, employment, and Social Security number. You’ll probably need documents like pay stubs or statements from your bank accounts to prove your ability to pay off the loan.
  3. Approval and Verification: The lender will do a hard credit check at this stage. This can temporarily dip your credit score by a few points. They review everything, including your debt-to-income ratio, to confirm you can afford the loan before making a final loan offer.
  4. Getting Your Money: After you’re approved and sign the loan agreement, the funds are sent to you. This usually happens within a few business days, often as a direct deposit into your checking account.
  5. Repaying the Loan: Your first payment will be due about a month after you get the funds. You’ll make fixed monthly payments for the entire loan term until it’s all paid off. Many lenders offer autopay so you never miss a payment.

The Federal Trade Commission suggests that checking your own credit report is a good first step before you apply for a personal loan. This gives you a chance to dispute any errors that might be hurting your credit scores.

Unpacking Interest Rates and APR

The cost of borrowing money is where things get interesting.

Two terms you must know are interest rate and Annual Percentage Rate (APR). While they sound similar, they are not the same thing.

The interest rate is the percentage the lender charges you just for borrowing the money. The APR, or annual percentage rate, includes the interest rate plus any fees the lender charges. Fees could be an origination fee for processing your loan, for example.

Because the annual percentage includes fees, it gives you a more complete picture of the loan’s total cost. A low interest rate might look appealing, but a high origination fee could make the loan more expensive overall. Always compare the APR when shopping for loan rates.

Most personal loans have fixed interest rates. This means your personal loan rate and your monthly payment will stay the same for the entire loan period. This predictability makes budgeting much easier than dealing with variable credit card rates that can go up at any time.

Debt Type Balance APR Monthly Payment Time to Pay Off
Credit Card $20,000 22% $600 47 Months
Personal Loan $20,000 11% $655 36 Months

In the table above, the personal loan has a slightly higher monthly payment. But because the percentage rate is half that of the credit card, you pay it off much faster. You also save a huge amount on interest charges, making it a smart financial move.

Let’s Talk About Repayment Terms

The repayment terms are simply the length of your loan. Personal loan terms usually range from one to seven years. The term you choose has a big impact on both your monthly payment and the total cost of the loan.

A shorter term means higher monthly payments. But you’ll pay the loan off faster and pay less in total interest. This is the most cost-effective option if you can afford the payments.

A longer term means lower, more manageable monthly payments. However, you will pay much more in interest over the life of the loan. A good loan calculator can show you exactly how much more you’ll pay in interest with a longer term.

How Does a Personal Loan Work with Debt Consolidation?

This brings us back to why you might be here. If you’re buried under credit card balances, you want to know how a personal loan works for debt consolidation. The goal is to simplify your finances and save money on interest.

First, apply for a debt consolidation loan that is large enough to pay off all your credit card balances. If you are approved, you get the lump sum of cash from the lender.

You then use that money to pay each of your credit cards down to zero. After that, you stop using those credit cards while you focus on your one loan payment. These types of consolidation loans provide a clear path out of debt.

Your new single payment should be lower than the combined total of all your old minimum payments, and it comes with a fixed end date. Taking on debt consolidation loans is a serious step, so make sure the math works in your favor.

Secured vs. Unsecured Personal Loans

There are two main categories of personal loans. You’ll find they are either secured or unsecured.

Most personal loans are unsecured loans. This means you do not have to put up any collateral to get the loan. The lender approves your application based on your creditworthiness, which includes your credit score and income.

There is more risk for the lender, so interest rates might be higher. An unsecured loan is a good option if you have strong credit and don’t want to risk any assets.

A secured personal loan needs collateral. You might use your car, which is similar to an auto loan, or a savings account to secure the loan. If you fail to repay the loan, the lender can take your collateral to get their money back.

Because there is less risk for the lender with secured loans, you might get a lower interest rate with a secured personal loan. This can be a helpful option for borrowers with bad credit. Some lenders may even allow you to use a money market account as collateral.

Where Can You Get a Personal Loan?

You have several options when looking for a personal loan. It’s a good idea to shop around to find the best terms for your situation.

Traditional banks are a common place to start, especially if you already have checking accounts or savings accounts with them. They often have competitive personal loan rates for customers with good credit. However, their approval process can sometimes be slower.

A credit union is another great option. As member-owned nonprofits, credit unions often give lower interest rates and have more flexible terms than banks. You do need to become a member to get a loan.

Online lenders have also become very popular. They operate entirely on the internet, which keeps their costs down. This can result in a competitive loan rate, and their application and funding processes are usually very fast.

Factors That Influence Your Loan Approval & Rate

Several factors determine whether you get approved for a loan and what your personal loan rate will be.

Credit Scores

Your credit score is one of the most significant factors. A higher score shows a history of responsible borrowing, which makes you a less risky applicant. Lenders reward high credit scores with better interest rates and terms.

Before applying, consider using a credit monitoring service to check your scores from all three bureaus. This allows you to spot and correct any errors. Even a small increase in your score can lead to significant savings over the life of the loan.

Debt-to-Income Ratio

Your debt-to-income ratio (DTI) compares your total monthly debt payments to your gross monthly income. Lenders use this to gauge your ability to handle a new monthly payment. A lower DTI is always better.

Most lenders prefer a DTI below 43%, and some have even stricter requirements. If your ratio is high, paying down some existing debt before you apply for a new loan can improve your chances. It demonstrates financial discipline to a potential online lender.

Employment History and Income

Lenders want to see a stable and sufficient source of income. They’ll verify your employment and look at your pay stubs or bank account deposits. A steady job history indicates you’re likely to continue making payments on time.

If you’re self-employed or have variable income, you may need to provide more documentation, such as tax returns. Lenders just need to feel confident that you have the cash flow to repay the loan.

What Happens If You Miss a Payment?

Life happens, and sometimes a payment can be missed. If this occurs, a few things will likely happen.

First, you’ll probably be charged a late fee. This amount is outlined in your loan agreement. These fees can add up, making it harder to catch up.

Second, lenders report payments to the credit bureaus, usually after they are 30 days past due. A late payment on your credit report can lower your credit score, making it harder to get auto loans or business credit cards in the future.

If you think you’re going to miss a payment, the best thing to do is contact your lender right away. Many lenders offer hardship programs or may be willing to work with you. Communication is much better than ignoring the problem.

Conclusion

A personal loan can be a powerful financial tool, especially when dealing with high-interest debt like student loans or credit card balances. The process involves borrowing a lump sum of money that you repay in fixed monthly installments over a set period. 

By understanding interest rates, repayment terms, and the difference between a secured personal loan and an unsecured loan, you can make an informed choice. From banks to credit unions, there are many places to find a loan that fits your needs.

Not all loans are the same — interest rates and terms can vary a lot. LendWyse gives you a clear side-by-side view, so you know exactly which option is the best fit for you.