How Do Personal Loans Work?

A personal loan may help you fund a big purchase or pay off higher-rate debt. Here’s what to consider.

Whether you’re planning a vacation, paying off debt, or preparing for a wedding, you have options beyond credit cards. For many people who are considering a large expense, personal loans may offer a lower-interest-rate alternative to credit cards and are more widely available than ever.

Banks remain a popular source of personal loans: In 2020, about 56% of borrowers secured their loan from a bank, while about 32% borrowed from an online lender, and about 26% took out money from a credit union. Of this group, online lenders are a fast-growing segment.1 In 2020, nearly 56% more people said they used an online lender for their personal loan compared with 2019.1

From 2010 to 2020, the number of individuals taking advantage of personal loans skyrocketed from 11 million to 21 million.2 With the increasing popularity of personal loans, those thinking about paying off their next big expense may still have some questions.

So, how do personal loans work?

What’s the Difference Between a Secured and Unsecured Loan?

There are two types of personal loans: secured and unsecured. Secured loans require you to put up collateral — like a car, real estate, a boat, or another investment — before borrowing money. Unsecured loans don’t require collateral, so lenders rely more heavily on a person’s credit score and debt repayment history to determine whether they qualify for a loan. Unsecured loans tend to be more common than secured loans, so let’s take a deeper look at how unsecured personal loans work.

How to Apply for a Personal Loan

Personal loans can be used for a variety of reasons, and most providers don’t limit the use of the funds to a certain area. Some of the top uses for personal loans include debt consolidation, medical expenses, home renovations, vacation, and moving costs.1 Regardless of why someone is considering a personal loan, there are four steps that can help make the process easier to follow.
 

4 Steps to Apply for a Personal Loan

Complete the checklist below:

Step 1: Figure out how much to borrow1

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It may sound obvious, but the first thing you’ll want to do before applying for a loan is calculate how much money you’ll need. Some lenders might charge an origination fee, which may be deducted from your loan amount. This fee typically ranges from 0% to 8% of the total borrowed, depending on factors like your credit score, terms of your loan, and state of residence. So be sure to take that into account when figuring out the final sum to apply for.

Step 2: Compare offers2

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Many lenders let you prequalify for a loan. By filling out an application with information like your name, date of birth, the last four digits of your Social Security number, purpose of loan, and desired loan amount, you can see which offers you qualify for. Prequalifying only results in a soft credit check, which shouldn’t impact your credit score. Compare rates to make sure you’re getting the best deal.

Step 3: Apply for the loan3

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After you’ve selected an offer, it’s time to apply for your loan. You may need to provide at least three things: proof of identity — such as a driver’s license, passport, or birth certificate — proof of income — like paystubs, a W-2, or bank statements — and proof of address, such as a utility bill, lease agreement, or voter registration card.

Step 4: Accept your loan4

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In order to accept the terms of your loan, you’ll review and sign the loan agreement. Once you’ve accepted your loan, lenders will initiate a hard credit check, which might drop your credit score a few points. After your application is approved, the funds are typically deposited into your bank account within a week (and with some lenders, the next business day).

Bonus Step: Set up a repayment plan

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When it comes to paying off your loan, you’ll want to make a plan as early as possible. Setting up automatic payments with your chosen lender can be an easy way to ensure you’ll make on-time loan payments and help build your credit score.

Factors That Influence Your Interest Rate

Length of Term

When accepting a loan’s terms, you may have options when it comes to how long you have to pay it back. Unlike a credit card, which can lead to a rotating cycle of debt, personal loans are a set amount of money with a definitive repayment period.

The length of your term can impact on your monthly payment amount and interest rate. For example, agreeing to a shorter term means larger monthly payments, but it also typically means paying less in interest over time. A longer loan term may offer the comfort of a smaller monthly payment, but you will most likely end up paying more in interest by the time you’ve paid off your debt.

Credit Scores

Your credit score is another important factor when it comes to your loan’s interest rate.

According to The Ascent, a credit score is the most important factor lenders will look at when determining not only your creditworthiness but also your loan’s interest rate.3 Lenders typically break down scores into the following categories:4

Amount Borrowed3

The amount you are asking to borrow can also impact your interest rate. Because lenders are at a greater risk of losing money with larger loans if a borrower doesn’t pay back their debt, a larger loan will typically carry a higher interest rate.

Repayment Terms3

As part of accepting a loan’s terms — including how much you’re going to borrow — you will also agree to repayment terms, or how long you plan to take to pay back the full loan. The longer your repayment period, the higher your interest rate is likely to be.

Debt-to-Income Ratio3

Your existing debts may also impact your interest rate. Lenders will look at a potential borrower’s monthly or annual income compared to their current debts — also known as debt-to-income ratio — to get an idea of how weighed down by debt they are. A higher debt-to-income ratio is likely to trigger a higher rate.

With an understanding of how interest rates on personal loans work, it’s also important for potential borrowers to consider the long-term impact personal loans can have on their financial well-being.

What Impact can Personal Loans Have on Credit Scores?

Your credit score is used for almost any major purchase you’ll make: buying or renting a home, buying or leasing a car, opening a new line of credit, and more. Your credit score comprises five major categories:5

35%: Payment history

Your track record of paying back previous debts can help or hurt your score. Timely repayment will give your credit score a boost, while missing payments can potentially lower it.

30%: Credit utilization

Your credit utilization is calculated by dividing the amount of credit you’re currently using by your total credit limit. A lower credit utilization score can help contribute to a higher credit score and vice versa.

15%: Credit history

The longer you’ve held lines of credit, the greater the chance for a higher credit score because credit bureaus may view you as an established and responsible borrower.

10%: Credit mix

Different types of debt — including student, auto, credit card, and mortgage — may help boost your credit by showing you can responsibly handle different types of credit.

10%: New lines of credit

Credit bureaus will look at any new lines of credit you’ve recently opened. Opening several new lines of credit in quick succession or initiating too many hard credit checks — which occur when you apply for a new line of credit — can also take a toll on your credit score.

At each step of the personal loan process, from shopping around to paying it off, your actions may have an effect on your credit score. Here’s what you need to know at each stage of your loan journey.

Pre-qualifying and comparing personal loan offers will trigger a soft inquiry on a borrower’s credit, which should not have any impact on your score. When you decide on an offer and apply for a loan, that will trigger a hard inquiry, which typically drops a borrower’s score by about five points. A hard inquiry may stay on your credit report for up to two years.6

Making on-time payments for your loan is the most significant way that taking out a personal loan can impact your credit score — for the better. A history of timely payments can help boost your score by showing creditors you are able to consistently repay your debts.

However, just like any debt, getting behind on payments for a personal loan can harm your credit score. Missing payments by a few days shouldn’t have an impact, but payments 30 days late or more may be reported to credit bureaus.

Lastly, if someone is using a personal loan to consolidate credit card debt, this can help improve their credit score by lowering their overall credit utilization. By consolidating debt from multiple lines of credit into one payment, your credit utilization score should go down and may help boost your credit score.

When you’re ready to take the next step on your financial journey, here are three actions to consider:

  • Assess your current financial situation, including any current debts you have and your financial objectives.
  • Evaluate how a personal loan may be the best option for you to help achieve your goals.
  • Research your loan options, comparing banks with the growing number of online lenders to find the best deal.

Ready to plan your next adventure?

See what the possibilities are with no obligation or impact to your credit score. Check your loan options now.

Sources:

  1. “Personal Loan Statistics,” March 8, 2021, Finder.com
  2. “Personal Loan Statistics for 2020,” Aug. 3, 2020, The Ascent
  3. “4 Factors That Affect Your Personal Loan Interest Rate,” July 21, 2021, The Ascent
  4. “What Is a Good Credit Score? How Do I Get a Good Credit Score?” Sept. 3, 2021, NerdWallet
  5. “What Affects Your Credit Scores?” May 31, 2017, Experian
  6. “How Does a Personal Loan Affect Your Credit Score?” July 6, 2021, NerdWallet
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