How Do Personal Loans Work? Discover Rates, Repayment And More
Hanna Kielar7-minute read
UPDATED: July 26, 2023
Available to borrowers through a financial institution, a personal loan can pay for a variety of expenses and be subsequently repaid through monthly installments to the lender. Of course, that’s a very simplified description of how a personal loan works. Much more goes into the process of getting and repaying a personal loan, and factors like interest rates and other loan terms warrant serious consideration.
Want to know how personal loans work and what borrowers should expect? Let’s take a closer look.
How Does A Personal Loan Work?
Personal loans are a type of installment loan delivered in a lump sum to a borrower and repaid monthly until the loan lender is reimbursed in full.
The application process for a personal loan is relatively straightforward, and approval can be quicker than with other types of loans, but a personal loan still involves many moving parts that can affect how it works.
Next, we’ll delve a bit deeper into the nuances of personal loans.
The type of personal loan you get can make a significant difference in how much the loan costs over time. Different personal types include:
- Unsecured personal loans, which are approved based on your credit and debt-to-income ratio (DTI)
- Secured personal loans, which are backed by collateral
- Fixed-rate loans, which come with a predetermined monthly payment and interest rate
- Variable-rate loans, which have a monthly payment that can change with the market rate
Personal loans are most often unsecured and have a fixed rate, but some lenders may offer options to lower your rate using collateral of similar or equal value to the loan amount.
A higher rate will mean a higher monthly payment and overall loan cost. If you find you don’t qualify for an affordable interest rate, it’s best to take steps to improve your credit and then try again.
Speaking of your credit score, a personal loan can have certain effects on your credit. First, applying for a personal loan requires you to undergo a hard inquiry, which can ding your score in a relatively minor way.
Additionally, missed payments and defaults can cause further damage to your credit and stay on your credit report for years. Inevitably, paying the loan off will also cause your credit score to dip, because the account is immediately closed upon repayment of the loan.
However, a personal loan can also do your credit good by diversifying your credit mix, which is an important part of your FICO® Score. And if you’re using the loan to pay down credit card debt, you can also help your score by lowering your credit utilization rate.
Distribution Of Funds
A lender will typically deliver a lump-sum personal loan into a borrower’s bank account within 1 – 7 business days of the borrower applying. With Rocket Loans℠, you might even qualify for same-day funding.*
If you’re using the loan for debt consolidation or to refinance another loan, your lender may be able to send the funds directly to your creditors or previous lender.
Once you receive your funds, expect to start making your monthly payments within 30 days of disbursal.
For a fixed-rate personal loan, your monthly payments are predetermined and depend on the length of your loan term and interest rate. Missed payments can result in a delinquent account, and a loan default if you stop making payments altogether.
The consequences of a default depend on your type of loan. If secured, your lender can repossess your collateral assets. If unsecured, your lender can send the unpaid loan to creditors who may file a lawsuit against you to reclaim the funds. Regardless, your credit score will suffer long-term damage.
Be mindful if your lender charges a prepayment penalty, because you’ll incur a fee if you pay your loan off early.
A typical term or repayment period for a personal loan is 12 – 60 months, with the potential to go longer. You can discuss a preferred term length with one or multiple lenders, but keep in mind that a longer term will cost more in interest over time while offering lower monthly payments.
Most personal loan lenders offer loan amounts of $1,000 – $50,000 for qualifying applicants. In rare instances, borrowers can take out as much as $100,000.
Where Can You Find Personal Loans?
You have a few options for finding a personal loan. Traditional banks and credit unions offer personal loans, and credit unions may even have special deals for members. A number of online lenders and lending platforms, including Rocket Loans, likewise exist.
Peer-to-peer lending has also grown into a viable financing option. Make sure to shop around and consider all options before committing to a loan.
Common Reasons For Personal Loans
As mentioned, a personal loan can serve a variety of purposes. Common uses include:
- Debt consolidation: Some borrowers use a personal loan to consolidate debt, such as credit card debt. The borrower pays off their outstanding debt with the loan so they’re only responsible for a single monthly payment and interest rate.
- Home improvement projects: You can use a personal loan as a home improvement loan to cover expensive home additions or renovations.
- Buying a vehicle: Some people will use a personal loan instead of an auto loan to purchase a car or vehicle. If your loan is unsecured, you won’t risk having your car repossessed.
- Emergency expenses: A personal loan can be used to cover unexpected or emergency costs such as medical bills and auto repairs.
Alternatives To Personal Loans
The fast and straightforward personal loan process can be ideal in most situations, but it doesn’t work for everyone. Take a look at some alternative financing options below.
Home Equity Loans And HELOCs
A home equity loan is secured by the equity in your home. Since the loan is secured, you’ll likely be eligible for a lower interest rate than with an unsecured personal loan. However, with your home’s equity acting as collateral, you could lose your home entirely if you default on the loan.
A home equity line of credit (HELOC) works much like a home equity loan, only instead of a lump-sum loan, it functions as revolving credit that you can borrow from and repay for the length of the term. Failing to make your payments on a HELOC can also result in you losing your home.
Personal Lines Of Credit
A personal line of credit (PLOC), like a HELOC, is a line of revolving credit that you can use for anything you’d take out a personal loan for. You can withdraw cash from a limited credit line during a “draw period,” followed eventually by a repayment period in which you’re expected to pay down your balance and won’t be able to withdraw money.
Unlike a personal loan, a PLOC has a variable interest rate that may fluctuate throughout your draw period.
0% APR Credit Cards
Credit cards are known for having high interest rates – the national average being around 19% – but some credit card companies offer an introductory annual percentage rate (APR) of 0%. This means you could sign up for a new card and enjoy a period of making payments without interest.
With big purchases or expenses, you’ll want to make sure you pay down the balance before the introductory period ends. Otherwise, you’ll risk facing high interest charges.
FAQs About How Personal Loans Work
Still have questions? See if we’ve answered yours below.
How long do you have to pay back a personal loan?
How long you have to pay back your personal loan depends largely on the length of your loan term, typically 12 – 60 months. If you want to pay your loan off early, look into strategies for paying off debt quickly.
Is a personal loan ever a good idea?
Getting a personal loan can be a good idea for borrowers with good or excellent credit and few other debts. Borrowers with lower credit scores may receive a high interest rate, if they’re approved at all. Consider your creditworthiness and the benefits of getting a personal loan to see if it’s right for your situation.
Does a personal loan go straight into your bank account?
Typically, your lender will distribute your funds directly into your bank account. Some lenders can even send the funds to creditors or other lenders if you’re using the loan to pay off debt or refinance. Some lenders may include this option on their loan application.
How do small personal loans work?
The minimum borrowing amount for many personal loans is $1,000. The repayment process for a loan this small should work as it would with a higher loan amount, but you’ll almost certainly have a shorter loan term.
Personal loans work like many other types of loans and are shaped by numerous factors, including loan type, duration of loan term, borrower creditworthiness, and more. Consider how the varying factors will affect your loan experience and decide if borrowing is the right move for you at this time.
Want to see your personal loan options? Start the process today with Rocket Loans!
*Same-day funding is available for clients completing the loan process and signing the Promissory Note by 1:00 p.m. ET on a business day. Also note, the ACH credit will be submitted to your bank the same business day. This may result in same day funding, but results may vary, and your bank may have rules that limit our ability to credit your account. We are not responsible for delays that may occur due to an incorrect routing number, an incorrect account number or errors of your financial institution.
Viewing 1 - 3 of 3
Personal Loan Requirements: How To Apply For Financing
Personal loan requirements vary from one lender to another. Uncover six steps to applying for a personal loan and learn the basics of personal loan eligibility.
How Many Personal Loans Can You Have At Once?
Taking out a second loan could help cover new or unexpected costs. Learn how many personal loans you can have at once,and the risks of repaying multiple loans.