How Do Personal Loans Work, And Are They Right For You?
Hanna Kielar6-minute read
UPDATED: August 03, 2023
A personal loan can finance a large purchase or expense you just don’t have the cash for right now. While personal loans are simpler and more straightforward than other types of loans, there’s still much to consider about how a personal loan works before you decide to apply for one.
Follow along as we uncover how personal loans work, the impact of your credit score on the process, how interest is determined and whether this is the right financing option for you.
How Does A Personal Loan Work?
Installment loans like personal loans are available at traditional banks, credit unions and private lenders. Here’s how the loan works: Upon its approval from a lender, you receive the funds in your bank account in a lump sum. With the money in hand, you’re free to then spend it how you intended.
A personal loan, as its name suggests, can be used for almost any personal expense, be that an expensive purchase, emergency cost or something else. Common personal loan uses include:
About 30 days after you receive your funds, your lender will begin charging you the monthly payments you agreed to make when you signed up for the loan. The amount of these loan payments will depend on the loan amount you were approved for, the length of your loan term and the interest rate. Your monthly payment may also be affected by the type of personal loan you applied for.
Many personal loan lenders charge origination fees, usually 1% – 10% of your loan amount.
Types Of Personal Loans
The most common personal loans are unsecured and have fixed interest rates, with loan amounts typically ranging from $1,000 to $50,000 (or more, in certain situations). Variations on personal loans include:
- Secured personal loans: Secured loans are backed by a valuable asset, or collateral, from the loan applicant. Collateral guarantees repayment of the loan, so lenders are more likely to offer a higher loan amount and a lower interest rate.
- Co-signed loans: A co-signer agrees to cover the loan if the borrower fails to make their monthly payments. As with collateral, this can open up the possibility of better loan terms and a preferred interest rate.
- Adjustable-rate loans: Adjustable rates fluctuate with the market, so you may have a lower interest rate one month and a higher one the next.
- Short-term personal loans: Personal loan terms are typically 12 – 60 months, but you may be able to request a shorter repayment period. Short-term loans generally have higher interest rates and fees.
- Long-term personal loans: In rare instances, some lenders may offer personal loan terms of 72 months or more. Long-term loans tend to cost more in interest over their relatively lengthy repayment period.
Rocket Loans℠ offers unsecured fixed-rate loans from $2,000 to $45,000, with terms lasting 36 to 60 months.
What Determines Your Interest On A Personal Loan?
The interest rate on an unsecured personal loan is largely determined by your credit score. For a good interest rate, your FICO® Score should be in the good to excellent range. Scores on the lower end may earn higher rates or not qualify at all. Personal loans typically require a minimum credit score of 580 to qualify, and at least 650 if you want a decent rate.
Lenders may also observe your debt-to-income ratio, or DTI, when reviewing your application. This measures how much you make in gross monthly income versus what you owe in monthly debts. In contrast to your credit score, the lower your DTI, the better your loan options will likely be.
The ideal DTI for a good personal loan rate is 20% to 36%. Some lenders may approve you with a DTI as high as 50%, but they would likely charge a higher rate for it.
How Personal Loans Work With Your Credit
Your credit score carries a lot of weight when you apply for a personal loan, but what does a personal loan mean for your credit?
The first way a personal loan impacts your credit score is with a hard inquiry, a part of the application process where a lender reviews your credit report. Unlike a soft credit check, a hard inquiry can mildly and temporarily lower your overall credit score. But the damage isn’t terrible, and your score will only drop by about five points. Even so, the inquiry can stay on your credit report for up to 2 years.
If you can’t make your monthly payments and end up defaulting on the loan, this can impact your credit in a more detrimental way. Missing payments can drop your score a hundred or more points, and a default will damage it even further and stay on your report for up to 7 years. This can make it more difficult for you to qualify for future financing.
A personal loan can have positive effects on your credit, too, though. For example, if using a personal loan to consolidate your credit card debt, you could see your credit score improve as you pay down your outstanding balances. Taking on a personal loan can also diversify your credit mix, raising your overall FICO® Score.
How Does Applying For A Loan Work?
Getting a personal loan is fortunately a very straightforward process, and it follows an order of operations similar to most loans. Follow these steps to get the funds you need:
- Check your credit report. Your credit score heavily influences your approval and rate, so it’s good to check your credit report ahead of time to make sure your score is where it should be.
- Decide how much you need. Consider the full price of the purchase you need financed, or the total balance of the debt you’re trying to consolidate. You can take out $1,000 to $50,000 from most lenders, so make sure you can get the amount you need.
- Shop around and compare lenders. Rates and terms will vary by lender, so look around and compare loan offers before deciding on one. Getting prequalified can give you the closest estimate for what a lender can offer you.
- Submit a full application. Once you choose a lender and are prequalified for an amount, gather the necessary documents and submit a full application. This step involves a hard inquiry.
- Wait for your approval and funds. After a certain amount of time, you’ll learn whether your application has been approved. If so, you’ll then receive your funds in your bank account within a few business days – and maybe even the same day you’re approved.1
Will A Personal Loan Work For You?
As you can see, a good amount of time and effort goes into getting a personal loan, and you have a lot to consider if you’re thinking of applying for one. If you want to know whether you should get a personal loan, the most important question to ask yourself is this: “Is my credit score strong?”
Borrowers with a low credit score will have a difficult time qualifying for a good interest rate – if they’re approved at all. If your personal loan rate is higher than the rate of the credit card debt you’re trying to consolidate, a personal loan may not be a good solution for you.
If your credit score looks too low to qualify for a good interest rate, take steps to repair your credit or consider other financing options.
Alternatives To A Personal Loan
Personal loans aren’t your only option for major expenses. Take a look at these financing alternatives.
Home Equity Loans
A home equity loan functions a lot like a personal loan, meaning you can spend it as you wish in most cases. The major difference is that a home equity loan requires collateral – in the form of your home’s equity – to secure the loan. Your approved loan amount and interest rate will be determined by the amount of equity in your home and your credit history.
With a home equity loan, you’ll also face a very different outcome if you default on the loan. If you can’t keep up with your payments, the lender can seize your home through the foreclosure process.
A home equity line of credit, or HELOC, is the revolving debt version of a home equity loan. You’re approved for a credit line of a certain amount with an agreed-upon timeframe in which you can withdraw funds. This is followed by a repayment period wherein you can no longer take money out.
As with home equity loans, your home secures the loan and can be taken from you if you fail to make all your payments.
Credit Cards With Promotional Offers
Some credit card companies offer promotional periods where a new cardholder can repay their card’s balance under a 0% annual percentage rate (APR). These introductory periods typically last 6 to 21 months, which may not be enough time to pay off your full balance, depending on how much money you put on the card. After the period ends, be prepared to pay regular credit card rates – which these days are around 20%.
On the surface, a personal loan works like this: A lender gives you money and you repay it over time. There’s more to consider about the workings of a personal loan, though, and this includes interest rates, how your credit affects what you’re approved for and how getting a personal loan affects your credit.
As with any type of loan, seek to understand the way a personal loan works and the terms you’re agreeing to before you decide to move forward. If you do this and have a healthy credit score, a personal loan may work in your favor.
Get the personal loan process started today with Rocket Loans.
1Same 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.
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