How Do Personal Loans Work? Understanding Payments, Interest & Repayment

Personal loans can be used for a wide range of purposes
3/11/19 | By Miranda Marquit
how do loans work

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Personal loan use has been on the rise in recent years, and credit bureau TransUnion expects to see a continual increase in personal loan borrowing in 2019.

We all need a little extra money now and then, so it comes as no surprise. It might be for an emergency, or maybe we just need to pay for a special event. Whatever the need, a personal loan might be able to help.

In a nutshell, a personal loan is usually unsecured and often packaged as an installment loan. As long as you can show an ability to pay, and you meet credit criteria, there’s a good chance that you’ll be able to get approved for one.

Before you jump in, though, here’s what you need to know to answer the question, “How do loans work?”

How personal loans work

Personal loans are similar to other types of loans. A lender assesses the risk you present and determines how much to loan you. Lenders charge interest, since you're using their money. Anytime you borrow, interest is the premium you pay for the privilege of using someone else's money to meet your goals.

You have a set loan term — usually between two and five years — and make regular payments for the set amount of time. As long as you make your payments on time and in full, a personal loan can help improve your credit.

Many personal loans are unsecured, meaning that you don't need collateral. However, there are some cases where you might need to provide an item of security that the lender can repossess if you don't make payments. If you have good credit and can show you can afford the loan, though, you probably won't need to provide collateral.

What can a personal loan be used for?

Personal loans are popular because they can be used for just about anything. And, it's no surprise that personal loans are the fastest-growing type of consumer debt, according to Experian.

Personal lenders want to make sure you aren't using their loans for education, but other than that, you can use a personal loan for a wide range of purposes:

Debt consolidation

If you have debt with high interest rates, a personal loan can be used to pay them off.

For those who qualify, a personal debt consolidation loan often has a lower interest rate and can help you save money while getting rid of your debt faster.

Medical bills

For those who need to pay for a procedure, but don't have the money available, a personal loan might be able to help cover your costs.

Before you turn to getting a loan, though, consider asking about a payment plan. In many cases, medical facilities will offer an interest-free payment plan. Explore your options, but know a personal loan can help you pay for needed medical care.

An emergency

We all face unexpected expenses. Perhaps your car needs repairs. Maybe you need to buy a new refrigerator.

According to the Federal Reserve, 40% of Americans can't handle a $400 emergency. If you find yourself struggling to cover an expense in an emergency situation, a personal loan could help smooth the way and cover the costs.

Home improvement

It's also possible to use a personal loan to make home improvements. Maybe you don't have enough equity in your home to use a home equity line of credit, or maybe you can get a personal loan at a lower rate.

In both cases, using a personal loan to improve your home can make it more comfortable and might even help increase the resale value of your home.

Moving

Planning a big move with the financial help of a personal loan could help cover some of your relocation costs. You might be able to secure a low rate and better manage your move without depleting your savings.

Special events

Weddings, honeymoons, and other special events can be paid for with personal loans as well. It's important to carefully consider your costs, and figure out how much debt you want to be in before you move forward, however. But if you're planning a special event, and you need a little extra cash to make it happen, a personal loan is a possibility.

What factors into getting approved for a loan?

With almost any loan, for any reason, there are factors that determine whether you're approved. Once you're approved, those factors also determine how much you can borrow and the interest rate you end up with.

The two main factors lenders consider are:

1. Credit score: Your credit score is a numeric representation of how you've handled credit in the past. The lower your score, the less likely you are to be approved. And, if you are approved, a low score will result in a higher interest rate.

2. Debt-to-income (DTI) ratio: Lenders also look at your income level in relation to your debt payments. If your monthly debt payments are high relative to your income, you might not be approved. Or, if your personal loan will impact your DTI, you might only be approved for a smaller amount.

Lenders consider these factors because they want to be reasonably sure you'll be able to repay the loan. Your DTI and credit score are some indicators they can use to determine how likely you are to repay the loan on time.

How much money can you borrow?

When getting a personal loan, the amount you can borrow depends on a number of factors, including your DTI, credit score, and how much you need.

Many personal lenders offer loans of up to $40,000, but there are some lenders, like SoFi, that offer up to $100,000 in unsecured personal loans. In order to qualify for large loans, however, you need to show adequate income and a high enough credit score that lenders feel comfortable risking that much money.

How interest is calculated

Many personal loans are calculated using simple daily interest and come with fixed interest rates. With simple interest, you're only charged on the loan balance.

Daily interest is based on your annual interest rate divided by 365. So, if you have a 4% interest rate, the daily rate would be 0.00011%. Practically speaking, if you borrow $10,000 at 4%, your daily interest charge would be about $1.10.

Your total interest charge is calculated at the beginning of your loan, and you make a set number of payments. Interest is accounted for in the total repayment schedule, so when you complete the term, everything is wrapped up.

How loan repayment works

With personal loans, most lenders set up a repayment schedule based on your interest rate and the size of the loan.

If you're willing to pay off the loan in three years instead of five or seven years, you're likely to get a lower interest rate. However, the shorter your term, the higher your monthly payments will be.

Personal loans amortize in a way that favors interest first. That means a large portion of your early payments will go toward interest charges, and then toward the end of the loan term, most of the payment goes toward paying off the principal. However, because personal loans are based on installments, and many of them are fixed-rate loans, you always have the same monthly payment.

Loan pitfalls to avoid

When looking for a personal loan, it's a good idea to watch for the fine print. Some of the items you'll find when exploring your options include:

  • Origination fees. These are fees paid just to get the loan. Often, they're rolled into the balance as part of the total and you pay interest on them. Some lenders, though, don't charge origination fees, so look for those lenders if you can.
  • Prepayment penalties. Some lenders charge a fee if you pay off the loan ahead of time since they don't get the interest they would have earned on the debt had you stuck to a longer repayment period. However, this practice isn't very common anymore and few lenders actually charge prepayment penalties today. Be sure to verify there are no penalties for paying your loan off early.
  • High interest rates. There are personal loans that come with interest rates above 35% APR. Watch out for these interest rates if you can. They can wind up costing you a lot more.

By shopping around and comparing terms, you can avoid some of the pitfalls associated with personal loans.

How to find the best loan rates

Personal loans are most effective when you can get a lower interest rate. A high-rate personal loan might be so costly that it's not worth it — especially if you're paying for a special event or another item that isn't necessary.

If you want the best loan rates, here are some things you can do to increase the chances that you will get a good deal.

Focus on your credit score

The number one thing you can do to get the best possible rate is to work on improving your credit score. A good credit score can open the door to being considered for the best personal loan rates.

Some moves you can make to improve your credit score:

  • Make all your payments on time and pay at least the minimum
  • Reduce the amount of debt you have overall, especially on credit cards
  • Be careful about how much credit you apply for

With a good credit score, you're more likely to get the best possible interest rate.

Shop around

Comparison shop for the best personal loans. You can do this by comparing different rates yourself from a variety of lenders. Consider going to your local bank or credit union, too. You might be surprised at what they can offer you.

Agree to a shorter term

The shorter you have the debt, the lower your interest rate is likely to be. Find out what your interest rate will be if you pay off the loan in 24 months instead of in 48 months. You might be able to knock off a little bit of your interest rate — and ultimately save money.

In the end, if you can present yourself as a smaller risk to the lender, they are more likely to give you a better deal on your interest rate.

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