Managing your finances with a personal loan: What you need to know
Key takeaways:
A personal loan lets you borrow a lump sum of money and repay it over time in equal payments.
Most personal loans don’t require collateral. In other words, you don’t have to own anything of value that you can borrow against.
A personal loan is one way to consolidate multiple smaller debts or cover a large expense.
It’s hard to hammer a nail into the wall using a screwdriver. Personal finance is like that, too. There’s a purpose for each of the different tools out there, and using the right tool makes the job a heck of a lot easier. Understanding different kinds of loans empowers you to make well-informed decisions that align with your financial priorities.
The world of loans is an alphabet soup where meanings aren’t always obvious. Let’s look at what a personal loan is, how they work, and examples of when a personal loan might help you reach your goals.
Personal loan definition
A personal loan is a chunk of money that you borrow from a bank or other lender. When you take out the loan, you’ll know how much the payment will be and how many payments you’ll make before the loan is paid off.
Key features of personal loans
No collateral required (usually)
Most personal loans are unsecured and don't ask for collateral.
For some loans, like car loans and home loans, you’re borrowing against something of value (collateral). The collateral is your guarantee that you’ll repay the loan. If you don’t repay the loan, your lender has the right to come after your collateral. Loans that require collateral are called secured loans. If you don’t have to pledge something of value to guarantee the loan, then it’s called an unsecured loan.
Flexibility to use funds as needed
When you take out a personal loan, you usually get the loan amount up front, in the form of a check or a deposit into your bank account. That gives you the flexibility to use the loan for different purposes. For example, you might use parts of the loan to pay off credit card debt, replace an appliance, or cover unexpected medical bills.
Predictable monthly payments
Most personal loans have a fixed interest rate. That means the interest rate won’t change for the life of the loan, and neither will the amount of your monthly payments.
The lender will tell you how much you can borrow, the loan fees, the interest rate you’ll pay for the life of the loan, and the length of the repayment period.
Why your credit score matters when you apply for a personal loan
Your credit score helps lenders decide how much you can borrow and how much interest you’ll pay. After applying, the bank or credit union will check your credit report at one or more of the national credit bureaus: Equifax, Transunion, or Experian. The higher your credit score, the more likely you'll be approved. If your credit score is lower, you might still be approved but with a higher interest rate.
Your credit score depends on your experience with credit accounts. Many factors go into your credit score. Some of the most important are your record of on-time payments and your credit card balances compared to your credit limits.
Before applying for a personal loan, check your credit report for errors. Some errors can lower your score, so you’d want to ask for corrections. You can get your current credit report at least once per year from each credit bureau for free from AnnualCreditReport.com.
Reasons people get a personal loan
One of the key features of personal loans is their flexibility. You can use personal loans to cover a range of needs.
Personal loans are often used to pay for large one-time expenses like home repairs and renovations or a wedding. It can be convenient to pay for large purchases like these over time on a fixed schedule.
Another reason people get personal loans is to cover large unexpected costs, like emergency car repairs, medical bills, or funeral arrangements.
You can use the money from a personal loan to make payments where credit cards aren’t accepted, for example for payments overseas, or for tuition payments at schools that still require payment by check.
Debt consolidation is another reason people get personal loans. If you’re currently making just the minimum monthly payment on one or more high-interest credit cards, then you may be able to save money on interest and fees by using a personal loan to pay off the debt. A single, fixed monthly payment may be easier to keep track of and gives you a timeline for payoff.
Frequently asked questions
Are there alternatives to a personal loan?
Yes, there are a range of alternatives to personal loans:
Home equity loan or home equity line of credit. If you own your home, you may be able to borrow against the equity you have in it.
Family loan. A loan from friends and family can come with less paperwork and more flexible repayment terms, which can be helpful if your income changes over time.
Credit card cash advance. For immediate expenses that have to be paid in cash, a credit card cash advance can give you almost instant access to cash. Cash advances tend to be an expensive way to borrow, and they add to your credit card debt. So you’d want to carefully compare your other options and look at the long term cost.
401(k) loan. Some employer 401(k) plans allow you to borrow money from your account and pay it back over a few years. This can be a low-cost way to borrow, but it’s not without risk. For instance, you might have to repay the loan in full immediately if you separate from your employer for any reason.
Retirement plan hardship withdrawal. The IRS allows you to withdraw money from your 401(k) account penalty-free under certain circumstances, such as to cover medical care or to repair damage to your home. Your employer would also have to allow it, and they can help you learn whether your financial need qualifies.
In-house financing for health care. Some doctors, clinics, and hospitals offer their own in-house financing. There are always conditions, so be sure you understand the agreement.
Who can get a personal loan?
You may qualify for a personal loan if you meet the lender’s minimum credit score requirement, you have enough income to afford the monthly payment, and you don’t have any disqualifying red flags on your credit report. For instance, some lenders won't approve a loan if you have unpaid collection accounts.
The amount you can borrow will depend on how much you can afford to pay, so if your income is higher you may find it easier to qualify for a higher loan amount. You may be able to improve your chance of approval or increase the amount you can borrow if you apply with a co-borrower. If you do, the co-borrower’s income and credit score will be considered. They’ll also be responsible for making payments on the loan.
Is a personal loan like a credit card?
A credit card has a credit limit that you can spend up to and repay repeatedly.
A personal loan is a one-time loan with repayment terms that are set up front. If you need more money later, you'll need to take out another loan.
Some lenders also offer personal lines of credit, which work more like a credit card.
