What Is a Personal Loan?

If you’re looking to consolidate debt or need to borrow money, a personal loan is an option to consider. Here’s what to know to help you decide if one is right for you.

How does a personal loan work?

A personal loan is an installment loan, meaning you borrow a predetermined amount of money and pay it back within a specified time frame, typically several months or years. Unlike a credit card, which can be paid off in varying increments, with a personal loan you make fixed payments on a regular basis, which can be a way to simplify your finances by giving you a more concrete idea of what you’ll owe every month.

Most personal loans have a fixed interest rate (some types have variable rates) that can often be significantly less than the interest rate on a credit card. This, however, will depend on your creditworthiness—the higher your credit score, the lower your rate. And unlike a mortgage or car loan, most personal loans are unsecured loans, meaning they are not backed by collateral (the home or car).

The process of taking out a personal loan

1. Choosing a lender: This can include a bank, credit union or online financial institution.
2. Submitting an application: When applying for a personal loan, you may need to provide information about income, employment, existing debts or other assets, with proof and documentation. A lender may also request information from you to perform a credit check.
3. Approval and receipt of funds: You may receive the money for your loan on the day you apply, or it may take several business days.
4. Paying back the loan: When you sign a loan, you’ll agree to repayment terms—detailing when you have to start paying back the loan and how big your payments need to be.

What should you use a personal loan for?

When taking out a personal loan, it’s important to consider what you can and cannot use it for. Here are some common reasons that people take out personal loans:

• Debt Consolidation: Personal loans are often used for debt consolidation, which is when you roll multiple bills, such as credit card balances and other debt like medical bills, into a single loan. However, you want to make sure that the interest rate for the personal loan is less than what you’re paying on your existing bills.
• Emergency Expenses: Emergency expenses can include car or house repairs, medical expenses or other sensitive situations. These kinds of loans may be necessary if you don’t have an emergency fund or if your emergency fund doesn’t cover your needs.
• Vehicle financing: While a personal loan may have a higher interest rate than what an auto dealership or bank can offer you, it’s still worth shopping around to make sure you’re getting the most bang for your buck.
• Small-business funding: If your business is cash strapped, a personal loan can help you cover rent, payroll and inventory instead of running up your credit cards. (Business loans can help here, too.)
• Home improvements: You can use a personal loan for improvements or repairs to increase your home’s value. Another option to consider is a home equity line of credit (HELOC), which is a line of credit borrowed against your mortgage that you can tap as needed, much like a credit card. While a HELOC can offer a more attractive rate than a personal loan, you may not have sufficient equity in your house to qualify for it.

What you should not use a personal loan for

While a personal loan can be helpful in many situations, you should be cautious about using one for expenses that don’t have long-term value, such as a lavish wedding or a dream vacation. Instead, save up for these events ahead of time so you’re not left making payments long after the event is over.

Here are some expenses that are probably not a good fit for a personal loan:

• College tuition: Student loans usually have more favorable interest and repayment terms than personal loans.
• Investments: Using personal loans for investments can be extremely risky; the market could have a downturn, and you will be on the hook for the loan. Also, your investment gains would have to cover the loan interest.
• A down payment on a home: Lenders usually will not allow borrowers to take a personal loan to make a down payment on a home, since a mortgage is its own type of loan.
• Living expenses and discretionary spending: Poor spending habits can begin to spiral into uncontrollable debt. Instead, build a monthly budget to keep your spending on track.

How to decide if a personal loan is right for you

You may be able to use a personal loan to help you get out of debt faster and at a lower cost. Of course, that will depend on whether the new loan’s interest rate is lower than what you previously had—even after you account for the fees. As you’re considering taking out a personal loan, here are some additional questions to ask yourself:

Can you pay off your credit card moving forward?

Using a personal loan to pay off credit card debt can give you clean slate. The last thing you want to do is open a new loan and then run your credit card balance back up. If you use a personal loan to pay down a credit card balance, make sure that you’ll be able to live within your budget and pay off your balance in full every month moving forward.

Have you read and understood all the terms?

If you decide to apply for a personal loan, be sure you fully understand the interest rate you’ll be paying, as well as the total annual percentage rate, which includes the additional fees attached to your loan. There may be other fees as well, including an origination fee (which compensates the lender for processing the loan) or a prepayment penalty, should you pay off the balance of the loan early.

Key terms to know if you’re considering a personal loan

Before taking out a personal loan, here are the most important terms you need to know:

• Amortization: The process of gradually paying off a loan through scheduled payments that cover both principal and interest
• Annual percentage rate (APR): The annual rate charged for borrowing, expressed as a percentage that includes interest and fees
• Borrower: The individual or entity that receives funds from a lender with the agreement to repay the loan
• Collateral: An asset the borrower offers to secure a loan, which the lender can take possession of if the borrower doesn’t make loan payments
• Cosigner: An individual who agrees to take responsibility for a borrower’s debt if the borrower fails to make a payment
• Default: Failure to meet the legal obligation of a loan, such as not making the required payments
• Fees: Additional charges associated with the loan
  • Application fee: A fee charged for processing a loan application
  • Origination fee: A fee charged by the lender for processing a new loan
  • Late payment fee: A penalty for not making a loan repayment by the due date
  • Prepayment fee: A charge for paying off a loan before its scheduled end date
• Fixed interest rates vs. floating interest rates: Fixed rates remain constant throughout the loan term, while floating rates change based on market conditions.
• Guarantor: A person or entity that agrees to pay a loan if the borrower defaults, providing an additional guarantee to the lender
• Installment: A regular payment made to repay a loan over time
• Loan agreement: A contract between a borrower and a lender outlining the terms and conditions of the loan
• Lender: The institution or individual providing the funds to the borrower
• Line of credit: A flexible arrangement where a borrower can access funds up to a specified limit
• Prequalified: An initial assessment by a lender to determine if a borrower might qualify for a loan and the potential loan amount
• Principal: The original sum of money borrowed in a loan, excluding interest
• Revolving credit: A credit system where the borrower can repeatedly borrow up to a certain limit, such as with credit cards
• Secured loans vs. unsecured loans: Secured loans require collateral, while unsecured loans do not and are based on the borrower’s creditworthiness.
• Terms: The conditions and duration of a loan agreement, including interest rate, repayment schedule and fees

How a financial advisor can help you decide if a personal loan is for you

While a personal loan can be helpful in some situations, developing a long-term plan can help you ensure you reach all of your goals, now and in the future. This is where your financial advisor can help.

Your advisor will ask questions to identify what is important to you and then help you design a comprehensive plan custom tailored to you. Your advisor can also show you how all the pieces of your financial life fit together—uncovering blind spots and helping you see opportunities to grow and protect your money.