Getting to know personal loans: how they work and how to get one

You’ve decided that it’s time to get it done. The only thing to figure out is the best way to pay for it. The “it” is up to you, but we can help with the figuring out part.  

Whether your goal is getting rid of high-interest debt, replacing your appliances, getting the dental work you need, or something else, a personal loan is a tool that can help you make your goal a reality.

When you understand how a personal loan works and how to get one, you can make a smarter decision about whether it’s right for your situation.

Personal loan basics

A personal loan is a lump sum of money that you borrow from a lender. Usually, the interest rate is fixed, meaning it won’t change for the life of the loan. That means your payment will always be the same. Also, most personal loans are unsecured. That means you don’t have to pledge a valuable asset as a guarantee that you’ll repay the loan. You can qualify for a personal loan based on your creditworthiness, not on whether you can offer the lender collateral.

When it comes to personal loans, the factors to pay attention to are:

• Your credit score and how it affects your costs

• The lender’s origination fees (the fee they charge for making the loan)

• The loan’s interest rate (the cost of borrowing)

• Your repayment term (the number of years you’ll get to repay the loan)

Your credit score and why it matters

Your credit score is based on your experience with credit. A history of making your payments on time is a big part of your credit score, along with the percentage of your overall credit you’re using, and how long you’ve had your accounts. Missed payments and maxed-out credit cards hurt your credit score.

Specifically, your score is based on:

• Your payment history

• How much your credit card balances are, relative to your credit limits 

• How old your credit accounts are (how long you’ve had them)

• How many times you’ve recently applied for credit

• The types of credit you have experience with 

Credit scores range from 300 to 850, and higher is better. For most personal loans, you’ll need a score of at least 620, although it’s possible to find lenders who accept applications from borrowers with lower scores.

Your credit score affects your personal loan costs because most lenders offer lower interest rates to people with higher credit scores. 

Origination fees (and “no fee loans”)

When lenders make personal loans, they’ll often charge an origination fee, sometimes called a lender fee. That’s their fee for processing the loan. It’s common for lenders to deduct this fee from your loan before you get the funds. So if a $5,000 loan has a 1% origination fee, then you’ll receive $4,950 but you’ll be responsible for paying back the whole $5,000.

Some lenders advertise loans with no origination fee. In those cases, the interest rate is higher. Lenders don’t make loans for free. 

What’s the interest rate?

Interest is the amount you pay your lender on top of the amount you borrowed. It’s based on a percentage of your loan balance. The lower the interest rate, the less you’ll end up paying over time. 

Different lenders offer different interest rates, even to people with the same credit score. The best way to find out what rate you might qualify for is to talk to a lender who does a soft credit check. That means you can check your interest rate without hurting your credit score. (When you submit a formal loan application, your score can temporarily dip by a few points, so applying isn't a good way to check rates.)

The length of your loan (your loan term)

Personal loans usually have a fixed repayment period (also called the loan term) and set monthly payments. You’ll owe the same amount each month. 

If you’re borrowing the same amount for a shorter period, your monthly payment will be higher, but you’ll pay less interest. A longer repayment period will often have lower payments, but you’ll pay more in interest over time. You’ll want to choose the term that works for your budget.

Steps to get a personal loan

If you’re thinking about taking out a personal loan, here’s what you can expect.

Decide on your goal and how much you need

How are you going to use the loan? Some lenders offer more favorable terms for loans if you’re using the money to pay off other debt. 

Smaller amounts and shorter terms can also bring the overall cost down.

Compare options

Even if you already have a relationship with a bank, they might not have the best loan for your situation. Consider reputable lenders that aren’t yet in your financial “circle.”

Check reviews in addition to costs and other details. Customer service is an important factor to consider. For example, can you get an agent on the phone if you have a question about your loan?

Be sure to ask about special offers. For instance, find out if you can get a discount off the interest rate. Lowering the interest rate is the best way to bring down the overall cost of the loan. Here are some of the ways you might qualify for a discount:

• Apply with a qualified co-borrower

• Let the lender use at least half the loan funds to pay off other creditors directly

• Show proof of sufficient retirement savings (not to be used as collateral, though)

Apply when your research is done

Once you’ve chosen the lender and you’re pretty confident in what kind of loan you’ll be offered (because you prequalified with a soft credit check), the next step is to apply. The lender will do a hard credit check and verify your income, address, and other details on your application. 

Once the lender approves your application, they’ll send you the formal loan agreement. If everything looks good to you, you can sign. The whole process is usually done electronically, although you might have to scan and upload any paper pay stubs if your employer doesn’t send them to you online.

Receive the money

When your loan is finalized, the lender will send out the money, either to your bank account or to your other creditors if you’ve asked for direct payment to them. This is usually within about a week but could be as soon as the day after you apply. If you’re paying off other debts, keep an eye on those accounts to make sure the payments show up correctly. Until the payments arrive, keep making your monthly payments, or you might be charged late fees or penalties.

How does personal loan repayment work?

Once you’ve taken out a personal loan, you’ll receive a statement each month either online or through the mail. The statement tells you how much to pay and when your payment is due. It will also show you the remaining amount of your loan. 

If you pay more than your monthly payment, you can pay off the loan faster and owe less in interest over time. Your due date is on the same day each month but some lenders allow you to request a payment due date that’s more convenient for you.  

Set up an automatic payment so that your payment is never late. Protecting your payment history is protecting your credit score and your ability to get the best price on financing in the future.

Tips to help you choose a good personal loan

While you’re choosing a loan, consider these questions in addition to the factors we’ve already discussed:

• Can you borrow the amount you need? Loan limits—and minimum loan amounts—vary. Find a lender that offers the right size loan for your needs.

• Can you get a better interest rate by improving your credit score? If the lender says you can get a lower interest rate with a 720 credit score and yours is 718, you might want to look at steps you could take to reach the next level. Qualifying for the lower rate will save you money for the entire life of the loan. 

Are there any unclear or hidden costs? Ask the lender to disclose all fees. Compare the APR for each loan you’re considering. The APR represents the total cost of the loan for one year, including interest and fees. Once you choose a loan, look at your loan documents carefully before you sign, to make sure there are no surprises.