How Personal Loans Work [An Introductory Guide]

Posted on October 25, 2018

From consolidating credit cards to taking a dream vacation, starting a business, or making home improvements, a personal loan can accomplish many of your goals

Thanks to the flexibility of personal loans, they are one of the most sought-after lending products. But, before you consider taking one out, you need to understand how personal loans work.

Understanding How Personal Loans Work

One of the key features of personal loans is that they are not secured loans. That is, there is no asset backing the value of the loan.

By comparison, a home loan is a secured loan. If you stop making payments on a secured loan like your mortgage, the lender can force the sale of the home to recoup its losses.

For this reason, secured loans tend to be less risky to the lender. This makes them easier for you to get as a borrower.

As a result of being unsecured, the lender has fewer options to recover these loans if you default on them. This is why personal loans are harder to obtain. Yet, once you get a personal loan, you can use it for anything that fits your needs and goals. That freedom is very attractive to a borrower.

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Deciding When To Get A Personal Loan

The investment in a personal loan is a good one in some situations. Most people should not obtain a loan they do not need. But, the flexibility of this type of loan means you may have plenty of ways to use it.

Most lenders are willing to provide you with a personal loan without knowing exactly how you plan to use it. Other lenders need to know exactly what your plans are for using the funds.

A component of this is based on your credit score and repayment history with other debts. However, you’ll want to make wise financial decisions for yourself here.

Some ways people choose to use personal loans include:

Paying off credit card debt

If you have high-interest loans, consolidating all of those debts into one personal loan may save you money. It also means you have one payment to make every month.

Adding value to your home

Make repairs to your home, upgrade the property, or add on an addition.

Making a down payment

Use a personal loan as a down payment on a new business, home, or opportunity. This may be viewed as riskier to a lender, but it is still an option to seek out if you are inclined.

Factors Affecting How To Get A Personal Loan

Obtaining a personal loan requires borrowers to show lenders they are capable of making payments on time. Having a good credit score and a reliable credit history helps.

Most lenders, including credit unions, provide personal loans based on a number of factors, including:

Credit score

The higher your credit score, the lower the interest rate you will pay on a personal loan. 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.

Debt-to-income ratio

This is the amount of debt you have compared to your income. Your lender wants to be sure you can take on the debt of a personal loan and make monthly payments easily.


You must show proof of income and allow the lender to verify that you have a steady, reliable source of income.

Comparing Personal Loans

You can obtain a personal loan from numerous types of lenders including credit unions and specialized lenders. However, you should always look through the terms of these loans. They will differ from one lender to the next.

How much can you receive?

Most people start here. However, don’t base your decision solely off how much of a personal loan the lender is willing to offer you. Borrowing more means you have a larger monthly payment, more interest to pay, and a longer loan term.

What is the interest rate?

As noted interest rates on personal loans tend to be higher than those on secured loans.

Nevertheless, those with good credit can still qualify for a good interest rate. Be sure to understand the APR or annual percentage rate. This shows you how much you will pay in interest over the course of the year.

What is the monthly payment?

When deciding on a personal loan, the monthly payment is essential. You should be able to easily make this payment each month. If it is too high, the lender may be able to extend the terms of the loan. This can provide a bit more flexibility to you.

What is the length of the loan?

The term, or length of the loan, tells you how long you will make payments until it’s paid in full. The shorter the term, the higher your monthly payment, but the less you’ll pay in interest over the life of the loan.

Be sure the lender does not put a prepayment penalty in place in the event you want to pay it off early to save money.

Making The Decision To Get A Personal Loan

Work closely with your credit union to learn more about your ability to obtain a personal loan.

Many individuals find this is an excellent way to accomplish their financial goals. The key here is to choose a lender you are confident in and one willing to offer you the flexibility you need.

You may also be interested in these related personal loan articles:


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