How Does a Personal Loan Work? [Beginners’ Guide]

Posted on April 10, 2023

A younger man listening to a financial advisor explain how personal loans work.

What Is a Personal Loan?
Pros and Cons of Personal Loans
How Do I Apply for a Personal Loan?
What Should I Look for in a Personal Loan?
When Is a Personal Loan a Good Idea?

From consolidating your credit card debt to planning your next vacation, making home improvements, or rebuilding your antique car—a personal loan can bring you closer to your goals and dreams.

Personal loans are flexible, convenient, and easy to apply for. But before you consider taking one out, it’s essential to understand how they work.

What Is a Personal Loan?

A personal loan is a lump payment of cash borrowed from a bank or credit union that you can use to pay for almost anything and that you pay back with interest over time. If approved, you can receive cash within a day or two. 

Most types of personal loans are not secured. This means you aren’t offering an asset such as a car or a home as collateral to guarantee the loan, which your lender could potentially seize if you failed to repay your loan on time.

For this reason, unsecured personal loans are usually for relatively small amounts that your lender is reasonably confident that you can repay on time. While your lender will typically charge a higher interest rate, this is normally well below other types of easy-to-access credit.

That said, you’ll also pay a higher annual percentage rate (APR) if you have a poor credit history. And while lenders may allow you to repay what you borrow in anything from a few days to several years, remember that you will probably pay more in interest payments the longer the term of your loan.

On the plus side, interest rates on personal loans—unlike almost any other kind of unsecured borrowing including credit cards or lines of credit—are usually fixed for the duration of your loan. This means you will know exactly how much you will need to pay back every month and how much you will end up paying in total over the life of your loan.

Pros and Cons of Personal Loans

That combination of convenience, flexibility, and transparency, and that the money has few strings attached, make personal loans a popular way to pay for things. But it is also important to keep some potential drawbacks in mind. So let’s summarize both the advantages and disadvantages of personal loans.

Important advantages of personal loans include:

  • Lower APR than credit cards
  • Longer repayment terms
  • Usually unsecured by collateral
  • Predictable monthly payment and total cost

Some potential disadvantages of personal loans include:

  • You will need excellent credit to qualify for the best APRs
  • You may not be able to borrow as much as you need
  • You must borrow the entire sum at one time, rather than borrowing a little at a time as you need the money

How Do I Apply for a Personal Loan?

Applying for a personal loan is typically fast and convenient. The process usually involves the following steps:

1. Check Your Credit Score

Your credit score remains the most important factor in determining what interest rate you will receive. Those with a poor credit score may not qualify for personal loans although it is never a bad idea to check with your bank or credit union.

2. Pre-qualify and Compare

Contact several lenders to see how much they are willing to lend you and on what terms. You usually do this by pre-qualifying for a loan, which involves a “soft” check of your credit that does not show up on your record.

Consider credit unions when looking for lenders. Unlike big commercial banks or online lenders, local credit unions are directly invested in the success of their members. Therefore they’re more likely to take a careful look at other factors, such as your income or debt-to-income ratio as well as why you need the money when offering you a loan.

3. Choose Your Loan

With a few offers in hand from potential lenders, it’s time to make a decision. Think carefully about how much you really need to borrow and whether you will really be willing and able to continue to pay back your loan over time. Be sure to also ask about fees you might be charged while applying for or paying back your loan.

4. Gather Your Documents

Once you’ve decided, you’ll need to gather important documents and complete an application. Be prepared to show proof of identity and address, proof of employment, details about how you typically spend your money, and any other debts or liabilities you may have.

5. Pay Fees, Get Approved, and Receive Funds

Lenders may ask you to pay loan application, processing, or origination fees up front if they charge them. If everything is in order you’ll receive a lump sum payment into your checking account in as little as a few hours to a few days. It’s now up to you to spend the money wisely and make steady repayments on your loan.

What Should I Look for in a Personal Loan?

Here’s what to look for as you evaluate pre-qualified personal loan offers from several lenders.  

How Much Are They Offering?

A lender might not be willing to extend you the full amount you asked for, or could even offer more. But remember, borrowing more means you will have to make a larger monthly payment, pay more interest over time, or commit to a longer loan term.

What Is the Interest Rate and Length of the Loan?

The interest rate, or APR, will vary by lender but needs to be evaluated in combination with the length of your loan. While you want the lowest interest rate you can get, if it is paired with a longer term you could end up paying much more over the life of the loan.

Be sure to ask for the total cost of borrowing for the full term of your loan—meaning the amount you borrow plus the full interest charged over the life of the loan. This way you’ll know from the beginning exactly how much you will repay in the end.

What Is the Monthly Payment?

One of the biggest advantages of personal loans is the single, fixed payment you will make for the life of your loan. While you need to be absolutely sure you will be able to afford to pay this every month for the term of the loan, you should also not accept a lower payment in exchange for agreeing to a longer loan term because you could end up paying significantly more over time.

Again, ask to see the total cost of borrowing for your full loan term so you can see how the monthly payment, APR, and loan term all work out. While it’s tempting to have more money in your pocket every month, you should try to pay as much as you can afford so you can pay down your loan sooner. 

Fees and Penalties

Once you know the total cost of your loan, add in any additional fees you could pay. Be aware of what you are paying and how much the fees can really cost you:

  • Application, origination, and processing fees may be charged upfront—even if you don’t get approved.
  • Prepayment fees may be charged if you want to pay off your loan early to recover some of the cost of the interest you are avoiding paying.

When Is a Personal Loan a Good Idea?

Personal loans make sense when they are used to pay for things that will improve your prospects, open up future opportunities, or improve the value of something you already own. Good examples include consolidating debt, buying computer equipment that will help you at school or work, or undertaking improvements that will increase the value of your home.

Personal loans are also a wise option when they are used to help pay off debts with higher interest rates, or to manage unexpected expenses you would otherwise need to pay by using a credit card or borrowing against your paycheck—for example, unforeseen medical expenses or car repairs.

Either way, a good personal loan can help you protect your financial future and work towards your dreams. Talk to a loan specialist today at Partners Financial Federal Credit Union. We’ll help you find an affordable loan that matches your individual needs. Or click below to learn more about how a Partners Financial FCU personal loan can bring you closer to your financial goals.


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