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How Do Personal Loans Work?

Breaking down how personal loans work and how to go about finding the best option for your situation.

Woman peeking over handful of money
Woman peeking over handful of money

Image source: Getty Images.

Whether you’re facing an unexpected expense you can’t cover, longing to buy something you just don’t have the money for, or hoping to consolidate existing debt, personal loans can be a useful financial tool.

However, nothing in life is free. If you’re not careful, a personal loan can cost you thousands in interest and leave you with monthly payments you can’t afford. Keep reading to understand what personal loans are, how they work, and whether or not they’re right for you, so that you can find the best personal loan for your needs.

What is a personal loan?

A personal loan is money lent by a bank or credit union to a borrower in a lump sum. The loan plus interest fees, which are determined by the your credit score, are paid back in monthly installments over a predetermined period of time, called the loan term. Unlike other loans meant to be used for a specific type of purchase, such as a home or car loan, personal loans can be used for a variety of purposes.

Can you get a personal loan for anything?

Personal loans can be used for almost anything. The most common uses for personal loans are medical expenses, debt consolidation, and home renovations. They’re often used for small business purchases, unexpected expenses, vacations, and weddings.

It’s up to the lender to determine whether or not they want to approve a loan for a given purpose, and most do have a few restrictions when it comes to the use of the loan. You typically can’t use a personal loan to pay your college tuition, although they can be used for personal expenses while in school, such as rent or textbooks. Many lenders won’t let you use a personal loan to pay off your student loans, either. Gambling is typically restricted.

What credit score do you need to qualify for a personal loan?

The higher your credit score, the lower your interest rate. Most traditional banks require good or excellent credit in order to qualify for a personal loan. Thanks to online lenders, there are options for people with fair and bad credit who need personal loans as well. However, these loans will come with high interest rates, so they might not be worth the cost.

Personal loans with a 700 credit score

If your FICO® Score is at 740 or higher, you’ll likely qualify for the best low-interest personal loans. Even with a score between 700 and 740, you’re likely to get approved for a personal loan with most lenders, although your interest rate may be a little higher.

Personal loans with a 600 credit score

Once your FICO® Score falls below 700, it becomes more difficult to qualify for a personal loan with a traditional bank. However, it is possible to get a personal loan with fair credit. Most online lenders only require a credit score of 640 or 670, and some will even approve applicants in the low 600s and high 500s. That being said, you won’t get a good interest rate, and if your score is closer to 600 than 700, you’ll likely have to pay a high premium for any loan you’re approved for, so it’s probably wise to focus on increasing your score before you borrow money.

Personal loans for bad credit

While there are options for personal loans with bad credit, it’s rarely wise to take advantage of them unless you’re truly in an emergency. Payday lenders and online lenders catering to people with bad credit often charge interest rates in the hundreds, which could easily land you in unmanageable debt and even lead to bankruptcy.

What to look for in a personal loan

It’s important to read the fine print when taking out a personal loan. Rather than go with the first lender that approves you, pay attention to the following key features.

Credit and income requirements -- Applying for dozens of personal loans until you’re finally approved will cause your credit score to drop. Instead, read through each lender’s minimum credit score requirements to make sure you qualify before applying. Some lenders also have income requirements.

Interest rate -- This is arguably the most important feature to pay attention to, as it’s the main determinant of how much your loan is going to cost you over time. You want to secure the lowest interest rate possible.

Loan term -- Your loan term is how long you have to pay off the loan. You want to pay off your loan as quickly as possible to save money on interest, but remember that shorter loan terms do mean bigger monthly payments. You never want to accept a loan with a monthly payment you can’t afford.

Loan amount -- Personal loans can range from $1,000 to $50,000. Take out enough to cover the cost of your purchase, but never borrow more than you need.

Origination fee -- Some lenders charge an origination fee, which is essentially a loan processing fee. These are typically a percentage of the total loan amount. Look for loans with minimal or no origination fee.

Prepayment penalty -- A prepayment penalty is a fee that a lender can charge you if you repay your loan early, or before the loan term ends. You should avoid loans with prepayment penalties as it’s always best to pay off your loan ahead of schedule when you can.

How to get a personal loan that’s right for you

Choosing the right personal loan for you involves careful deliberation and a lot of research. Here are some tips to help you find the best personal loans.

  • Shop around. Check the rates and credit requirements for all major lenders, including online lenders, traditional banks, and credit unions.

  • Evaluate your budget. Decide how much you can afford to pay each month so that you know ahead of time what your monthly payments should be. This will also impact how much you can afford to borrow.

  • See if you prequalify. Most lenders have a prequalification process that allows you to see what kinds of personal loans you might qualify for before applying. As long as this process doesn’t involve a hard pull on your credit report, it won’t impact your credit score.

  • Complete an application. Based on your prequalification results, apply for a personal loan with a lender that is likely to approve you and offers the lowest interest rate. Pay attention to other fees and make sure the lender’s loan amounts and loan terms fit your needs.

  • Accept an offer. If you’re approved for a personal loan, read through the terms fully before agreeing to the offer. Once you’ve accepted the offer, you should receive your funds shortly.

Personal loans vs. credit cards

If you need to borrow money, it’s worth considering credit cards in addition to personal loans. The table below compares the benefits of each option.

Personal loans

Credit cards

In most cases, personal loans are a more affordable way to borrow money than credit cards. However, if you can pay your credit card bill in full each month, credit cards allow you to borrow money for a short period of time without paying interest. Furthermore, if you can qualify for the best 0% APR credit cards, you can borrow money without paying any interest at all -- as long as you pay it back before the introductory period ends, which is usually 12 to 18 months.

If you need to borrow a large amount, or if it will take you more than a year and a half to repay the amount borrowed, you should opt for a personal loan. If you’re certain you can repay the amount borrowed in less than a year and a half, and you have good credit, consider a 0% APR credit card. Finally, it’s hard to find personal loans for under $1,000, so if you’re simply finding yourself short a few hundred dollars now and then, consider applying for a good low-interest credit card or a credit card from your local credit union.

Is a personal loan a good idea?

Taking out a personal loan is a decision that should be made carefully, as it puts you in debt, which costs money and impacts your credit. Here are some examples of good reasons to take out a personal loan, as well as reasons not to get a personal loan.

When you should consider a personal loan:

  • To pay for emergency expenses, such as medical bills or car repairs.

  • To cover purchases that will provide a return in the future, such as home improvements or small business expenses.

  • To pay off existing high-interest debt, such as credit card debt, but only if you qualify for a lower interest rate or better loan terms.

  • You have good credit, can qualify for a low interest rate, and you’re sure you can afford your monthly payments.

When a personal loan might be a bad idea:

  • You need extra money to pay your college tuition -- personal loans can’t be used for this.

  • You want to treat yourself with an unnecessary purchase, like a vacation or a new suit -- save up the money instead.

  • You can only qualify for loans with high interest rates -- work on improving your credit score first.

  • You’re already struggling to pay your bills -- adding another bill into the mix won’t make your financial situation any easier.

  • You’re borrowing a small amount and could pay it off in a year and a half -- most lenders don’t offer personal loans in amounts under $2,000 or $1,000, and a 0% APR credit card with an introductory period of 18 months is a better deal if you can pay it off in time.

Debt should never be taken lightly. By understanding the benefits and consequences of taking out a personal loan, you can make an informed decision about whether or not a personal loan is right for you.

The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule. If we wouldn’t recommend an offer to a close family member, we wouldn’t recommend it on The Ascent either. Our number one goal is helping people find the best offers to improve their finances. That is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.