How Do Personal Loans Work?

A personal loan is a type of installment loan that’s usually unsecured. This means that you borrow a lump-sum of money and make fixed payments, with interest, in installments until your loan is paid in full. An unsecured loan doesn’t require collateral. This means primarily your credit score, credit history, income, and debts are used to determine your eligibility.

Key Takeaways

  • In order to be prepared for your personal loan application, you'll want to have your recent pay stubs, your personal information (your address, driver’s license, etc.), and your bank account information on hand.
  • For some lenders, you can check your eligibility for a personal loan via a pre-qualification process, which will show you what you might qualify for without dinging your credit score.
  • To ensure you never miss a loan payment, consider setting up autopay if your lender offers it. In some cases, you may even receive an interest rate discount for doing so.

How Personal Loans Work: The Process

You can use a personal loan for almost anything—that’s what makes them personal. You can use it to pay off outstanding debt, like medical bills, or make upfront payments on a big purchase, like a house or a car. Personal loans are commonly offered at banks, credit unions, and online lenders.

Before you get a personal loan, there’s a bit of work involved first.

Preparing for a Personal Loan

In order to be ready to apply for a personal loan, you’ll need to have your paperwork in order. This includes:

  • Recent pay stubs: You’ll need to prove you have a job with a steady income so that you can pay back a loan. You might also need recent tax returns if you’ve recently changed jobs or don’t have access to your pay stubs.
  • Personal information: A lender is going to ask about where you live, how much you want to borrow, what you’re planning to use the money for, and other details. You might need to provide your driver’s license, Social Security number (SSN), passport, and possibly some utility bills that have your name and address on them.
  • Financial accounts: To get money into your account, you’ll need to share your bank account information. This may also be where you make payments from each month when you begin your loan repayment.

You’ll also want to check your credit score and history before completing a full application. This allows you to be aware of what lenders will see and can also help you narrow down options. If you have excellent credit, you’ll have an easier time qualifying for a personal loan with a low interest rate and fewer fees. But a fair or bad credit score may limit your options.

Personal loans also have a few fees that you need to be prepared to pay, including an origination fee, which is used to cover the cost of processing your loan. This fee can range from 1% to 6% of the loan amount.

The Application Process

Some lenders will let you pre-qualify for a loan before submitting an actual application. Pre-qualification is when you input some credit and financial details and your potential lender lets you know if you might be eligible for a loan based on that information. This is not a hard credit pull, and your credit score and history aren’t impacted.

A pre-qualification can help you weed out lenders that won’t give you a loan, but not all lenders offer this option. You can compare as many lenders as you’d like through pre-qualification, that way you only have to complete an actual application with the lender that’s most likely going to approve you for a personal loan.

Interest rates vary by lender and your creditworthiness. The higher your credit score, the more likely you are to qualify for the lowest interest rate offered. The lower your score, the harder it’ll be for you to qualify for a loan, and even if you do, you could end up with an interest rate on the higher end of what’s offered.

There’s no universal standard for credit requirements across all lenders. There’s also no standard for repayment terms or the amount you can borrow. Try to compare lenders based on your needs along with your likelihood to qualify. If you need to borrow a small sum of money (or a very large sum), make sure your potential lender offers that amount before completing an application.

Once you have all your documents and details in order, completing an application can still take a little bit of time. Afterward, however, you should find out within a few moments if you’ve been approved for a personal loan.

Receiving a Personal Loan

Once you’re approved for your loan and have accepted it, you’ll input some banking details to get your lump-sum deposit. Different lenders have different funding times, which are also affected by when you complete your application. Some will deposit funds into your account within a day, while others might take a couple days to get to you.

Paying Back a Personal Loan

Many lenders give you the option to set up autopay and, in some cases, offer an interest rate discount for doing so. Autopay lets you set-it-and-forget-it so you never miss a loan payment. Payment history is the biggest factor when your credit score is calculated, and falling behind on loan payments can negatively impact your score. So setting up autopay, or even just a calendar reminder, so you’re always paying on time is incredibly important.

Your loan terms, interest rate, and how much you borrowed all determine your monthly payment. You can use a calculator to see which variables fit best into your budget. Many lenders don’t have prepayment penalties, so you likely won't have to worry about getting charged a fee if you pay off your loan early.

How Does a Personal Loan Impact Your Credit Score?

In the short term, completing a personal loan application causes your score to temporarily dip because a hard credit pull occurred. After a few months of on-time payments, your score will rebound. The new personal loan also diversifies your credit mix, which is part of your overall credit score.

Can I Get a Personal Loan if I Have Bad Credit?

You can get a personal loan with bad credit, but you might not get it from the lender you want. Not all lenders offer personal loans to borrowers with bad credit, so you’ll want to see if your lender discloses minimum credit score requirements (not all of them do) before you submit an application. Even if you’re eligible for a personal loan with bad credit, you could face much higher interest rates and potentially more fees compared to someone with excellent credit.

What Is the Risk of a Personal Loan?

A personal loan means a new source of debt, which you’re required to pay back. If you fall behind on payments, your credit score will tank, and it will become difficult to qualify for other borrowing options in the future, like taking out a credit card or getting an auto loan. Only take out a loan if you know you can make the required payments on time every month.

How Much Can I Get With a Personal Loan?

The amount you can borrow isn't the same across the board, as each lender has different minimum loan amount requirements. If you only need a small amount (i.e., a couple of hundred dollars) there may be some lenders you won't qualify for. It’s important to only borrow what you need, since you’ll have to pay that money back—with interest.

Are Personal Loans Better Than Credit Cards?

Both personal loans and credit cards are two options to borrow money up front, but they have different purposes. Consider what you need the money for before you choose your payment option. There’s no wrong choice, but one could be much more expensive than the other, depending on your needs.

The Bottom Line

Personal loans are a great resource if you need to borrow money and qualify for one. But they aren’t for everyone. If you don’t have great credit, you might need to get the help of a co-signer who agrees to your loan terms alongside you, taking on the legal obligation to pay down the debt if you're unable to. If you don’t have a co-signer, you might qualify for a personal loan with bad or fair credit, but you may not have as many options compared to someone with good or excellent credit. Consider alternatives, like a credit card, a home equity loan (if eligible), or borrowing from friends and/or family.

Article Sources
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  1. Consumer Financial Protection Bureau. "What Is a Personal Installment Loan?"

  2. Experian. "6 Personal Loan Requirements to Know Before You Apply."

  3. Experian. "5 Personal Loan Fees to Watch Out For."

  4. Experian. "Prequalified vs. Preapproved: What’s the Difference?"

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