A crash course on how personal loans work

Personal Loan Consideration - Handwriting on Notepad with Coffee and Calculator

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Credit Sesame explains how personal loans work.

A personal loan is an investment in your future self. Other types of loans, such as mortgages or auto loans, must be used for a specific purpose. A personal loan gives you a greater degree of flexibility. Learning how personal loans work helps you manage personal finances, achieve big goals and be a good steward of your credit.

Basic elements of a personal loan

A personal loan is a type of credit that a bank or online lending institution extends to help you meet a financial goal. These goals might include:

  • Consolidating several smaller debts into a single account that’s easier to manage with better payback terms
  • Covering an unexpected medical expense
  • Funding your continuing education
  • Paying for a small to mid-size home improvement project

Personal loans offer flexibility and financing capacity. They can be used broadly and are negotiated between you and a lender. You’ll likely have more credit to spend with a personal loan than a credit card.

This financial tool has clearly defined edges. Your lender determines the interest rate – often fixed – you pay and the period you pay it back.

Types of personal loans

Some personal loans are secured, while others are unsecured. Understanding this principle helps you decide how much risk to take on while meeting your lender’s expectations.

A secured personal loan means if you cannot pay your debt, the lender can take something of value from you. This might include a vehicle, a home or another asset. It gives the lender greater confidence that they can recover their money with interest if your financial situation changes. Secured personal loans often have lower interest rates because of this added financial security for the lender.

If you have limited assets of value, you might opt for an unsecured personal loan. This means the lender gives you funding without collateral backing you up if you cannot pay. To cover its bases, your lender might require a higher interest rate.

Many personal loans offer a fixed interest rate. This helps you predict precisely how much is owed each month. Some personal loans have a variable interest rate, which means you might owe less this month and more next month as the market fluctuates.

Advantages and disadvantages of personal loans

A personal loan can be attractive if you need money to cover expenses beyond your savings. Personal loans are available from various trustworthy lenders, both conventional and online only. You can shop around for interest rates, terms and other criteria that fit your financial situation best.

Personal loans can help you remain calm amid stress. An unexpected medical bill might normally throw off your budget for months. A personal loan could reduce stress because it lets you make payments over time versus all at once.

A final advantage of a personal loan is that you can manage it with other financial accounts. These include checking and savings accounts. You already know the ins and outs of your banking website or app. This can make tracking your personal loan and payoff progress a breeze.

On the other hand, personal loans come with potential disadvantages. Personal loans can become an excuse for spending beyond your means. Never pursue a personal loan unless you have mapped out how it impacts your monthly budget. Know the payback period and plan on fully paying what you owe each month so the loan doesn’t add more stress to your life. Paying extra is even better.

Another downside of personal loans is interest. If you can pay for something with cash savings, it might be best to start there versus opening an interest-bearing personal loan. A small-scale bathroom remodels funded with cash leaves you with a completed project and no debt. By contrast, a personal loan might mean you complete your remodel yet continue making payments for months or years to come.

A third watch-out with personal loans is their possible impact on your credit report and score. People with solid credit tend to have at least a couple of types of debt, so a personal loan can, in theory, be beneficial. Yet it’s important to make timely payments and avoid taking out too much new credit too quickly. Apply for a personal loan only when you understand how it could impact your credit health. Avoid falling behind on payments, which could negatively affect your score, and, in the worst-case scenario, send your bill to collections.

Tips for choosing the right loan and avoiding pitfalls

Several practical tips can help you ensure a successful personal loan experience. These tips include:

1. Identify your need.

Understand why you’re seeking a personal loan. Creatively examine all possible paths for covering that expense. Consider whether you need such a loan or might fund all or part of the cost with cash.

2. Do your homework.

Use Credit Sesame and other free resources to explore the types of personal loans available. Determine who offers the lowest interest rates and best overall terms. Avoid lenders that charge fees that seem unusually high or without a clear explanation. Your job at this stage is to limit risk to your personal finances while meeting a financial need.

3. Place inquiries.

Apply for a personal loan through one or two different lenders. See whose features best fit your need and your budget. Place these requests around the same time to avoid a negative impact on your credit report. An even better option might be to seek preapproval for a personal loan. This might not ding your credit at all.

4. Review proposed terms.

Assuming you qualify, the lender responds with an overview of the personal loan for which you are eligible. Take this opportunity to read slowly and carefully. Understand the interest rate you’ll pay, whether that rate is fixed or variable, and the timeframe for paying back the debt in full. Scan all documents to see whether the lender includes additional fees. Ask any questions to make sure you understand the numbers and your responsibilities once you have the loan. You can ask your financial adviser to take a look and give you a second opinion. Once these steps are complete, and you are sure you want and need a personal loan, you can sign the documents and make the loan official.

5. Use your loan and begin payments.

Once your loan paperwork has been signed, you should have access to funds within a few business days. This enables you to use the personal loan for the expenses you’ve earmarked and triggers the start of your monthly payments. Honor the terms you’ve agreed to and make payments on time.

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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.

Nate Birt
Nate Birt is a personal finance writer with 15 years of experience as a journalist, business leader, and social impact executive. His company, Silver Maple Strategies, helps clients unlock the power of persuasive storytelling to capture imaginations and secure investment.

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