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What is a personal loan? How it works — and what to know before you apply

What is a personal loan — and how does it work? (skynesher via Getty Images)

A personal loan is money that you borrow to cover a one-time expense. The most common reason people use personal loans is to pay down high-interest debt, thanks to their relatively low interest rates compared to credit cards. They can also be a relatively inexpensive way to finance home improvement projects, like remodeling a bathroom, without tapping into your home equity.

Unfortunately, high interest rates mean now isn’t the ideal time to get a personal loan. It’s more difficult to qualify for a personal loan than it used to be — and those who do qualify won’t get the same low rates they would’ve received before 2020. However, this is true for credit across the board.

While not as inexpensive as they once were, personal loans can still be a good option for those who can’t wait for rates to come down.

A personal loan works by giving you a lump sum of money that you repay in monthly installments plus interest and fees. You can typically borrow between $2,000 and $50,000 — though some digital lenders like LightStream offer as much as $100,000. Generally, the higher your income and credit score, the more you’re eligible to borrow.

Repayment terms tend to range from two to seven years, though it’s possible to find terms as long as 10 or even 20 years in some cases. The longest terms are typically only available on the highest loan amounts.

The vast majority of personal loans are unsecured — which means they don’t require any collateral. You apply for the loan, and the lender reviews your application, providing you with your loan's terms that you can accept or reject.

It’s possible to find a personal loan secured with collateral like a CD or another non-liquid asset — for example, Upgrade is a digital lender that offers a choice of an unsecured loan or one secured with your car. Secured personal loans are often available at credit unions or community banks and may be easier to qualify for than an unsecured loan, because your lender can take the asset if you default on the loan to satisfy what you owe.

In most cases, personal loans come with fixed interest rates that remain the same as you repay the loan. This is great in a low-rate environment, because it ensures you won’t be surprised with high rates a few years into your term. But it’s not ideal when rates are high, because your rates won’t drop if the economic environment changes.

The most common way to lower a personal loan rate is to take out another loan with a lower rate and use those funds to pay down the original loan balance.

Understanding the difference between an annual percentage rate — more commonly called an APR — and the interest rate is key to understanding the cost of your loan.

Lenders advertise the cost of a personal loan with an annual percentage rate, which represents the interest rate and fees you pay over one year, expressed as a percentage of the loan balance. Factors that influence your interest rate and fees include your creditworthiness, loan amount and loan term.

Because it includes fees, an APR is often larger than a loan's interest rate. Advertised interest rates range from 8% to 36%, though the average interest rate on a two-year personal loan was 12.49% at the beginning of 2024, according to the Federal Reserve Bank of St. Louis. But it’s unlikely borrowers will see an APR this low because that number doesn’t include origination fees. Online marketplace LendingTree found that its users in the highest credit score range received an average APR of 16.01% during the last quarter of 2023.

Not all lenders charge fees, but some will charge an origination or processing fee that they either deduct from or add to your loan balance before you receive the funds. Origination fees can range from 1% to 6% of the loan amount, though sometimes they’re higher. For example, the online lender Upstart charges origination fees as high as 12% of the loan amount.

Lenders don’t factor late fees, returned check fees and other similar expenses into the APR, because those fees apply to specific, unforeseeable situations only.

There are three main numbers to consider when weighing the cost of a personal loan:

  • Monthly payment — this is the amount you pay each month toward the interest and principal. In a sense, this is the most important expense: If you can’t afford the monthly cost, you’ll default on the loan. Generally, lengthening your term will lower the monthly cost.

  • Total cost — this is the interest and fees that you’ll pay over the term of the loan. Since interest is an expense that accumulates over time, shortening your loan term will lower the total cost.

  • APR — this percentage includes the loan's interest rate and any fees, and it gives you a sense of how competitive a loan is compared to other options. Lenders often offer the lowest interest rates to borrowers with near-perfect credit applying for the highest loan amounts and the shortest terms.

To find a balance between lowering your monthly and your loan's total cost, opt for the shortest loan term with monthly payments that comfortably fit into your monthly budget.

Ideally, a personal loan is a strategic investment that increases your net worth. The most common way to use a personal loan is to consolidate debt, which involves taking out a loan to pay down one or more credit accounts at a lower rate. The average credit card interest rate was 21.59% in February 2024, according to the Federal Reserve — just over 10 percentage points higher than the average personal loan interest rate. That lower rate means more of your monthly payments will go toward the principal, in addition to lowering the total cost of the loan.

Another common reason to use a personal loan is to fund a home improvement project that’s too expensive to put on a credit card but not big enough to tap into your home equity — like a minor midrange kitchen remodel. Before you borrow, consider whether the investment is worth it: The boost to your home’s value should exceed the cost of the loan. Even if it doesn’t add to your wealth, it could still be worth the cost. For example, a home improvement that allows you to age in place comes with emotional benefits — on top of avoiding a pricey assisted living facility.

Personal loans can also be useful if you have a large one-time expense that you can’t pay for out of pocket and don’t have time to save up. Think weddings, funerals, traveling to help care for a new grandchild or other important life events.

You can also use a personal loan for medical expenses — but save it as a last resort. Many healthcare providers offer interest-free installment plans and other forms of financial assistance, even for elective procedures your insurance won’t cover.

Dig deeper: 4 ways to get equity out of your home while rates are high

Almost all lenders offer personal loans online these days. But there are several types of providers you may want to consider.

Banks are one of the safer choices. They tend to offer lower interest rates and fees than other lenders and are subject to federal regulations. But they also have the most stringent credit requirements, and many larger banks have stopped offering consumer financing altogether in recent years.

Credit unions may charge slightly higher rates than banks, but could be a good option for folks who can’t get a bank loan. These member-owned financial institutions aren’t beholden to shareholders and tend to have more relaxed credit requirements. If you aren’t already a member, you often need to open a checking or savings account with the credit union before you can borrow.

Online lending marketplaces like LendingTree and Credible allow you to compare multiple offers for free by filling out a form with basic personal information. These lending sites are convenient — they allow you to see the rates, loan amounts and terms that you might receive from several lenders in one place — but there are some downsides.

One main drawback is that they share your contact information with lenders, which means you could be fielding calls from partners for months. Another drawback is that you’re limited to their network of lenders, so you aren’t truly comparing every option available to you.

Online lenders are financial technology — or fintech — companies that offer personal loans without a brick-and-mortar location. Some, like personal finance company SoFi, have become online banks, but not all fintechs are regulated as rigorously as traditional lenders.

These companies often specialize in financing for people who struggle to qualify for a loan due to low credit or income. Many claim that the lower overhead cost means that consumers can qualify for lower rates and fees, but the focus on overlooked borrowers means that APRs can be higher than traditional lenders.

Every lender has its own requirements, yet many require you to meet the following general criteria to qualify for a loan:

  • Good or excellent credit score of 670 or higher

  • Annual income of at least $25,000

  • Debt-to-income ratio of no more than 36%

🔍 What is a debt-to-income ratio?

Your debt-to-income ratio — or DTI — is your pre-tax monthly income that’s used to pay your debts expressed as a percentage. Lenders use your DTI to understand how much of your income is available to cover a new loan payment and determine how risky it is to take you on as a borrower. Generally, the lower your DTI, the better your chances of loan approval and the best rates and terms.

You can calculate your DTI by dividing your monthly debt payments by your monthly income before taxes. So for example, if your mortgage payment is $2,000 and your car payment is $300 but you earn a monthly gross income of $5,000, your DTI would be 46%. Most lenders prefer your DTI to be under 43%, with 35% an ideal target.

Since lenders typically don’t advertise all eligibility criteria, the best way to find out if you’re eligible for a loan is to start an application. Most providers offer risk-free preapproval based on a soft credit check — a request that won’t affect your credit score. Preapproval allows you to make sure you meet the basic eligibility criteria and get an estimate of the rates and terms that you might receive.

If you prefer to work with a lender in person, you can also set up a meeting with a loan officer at a bank or credit union to discuss your eligibility.

Some lenders may prefer to work with borrowers who are employed full time. However, they legally cannot discount income from pensions, retirement accounts, Social Security or other government benefits programs when considering your application, thanks to the Equal Credit Opportunity Act. The ECOA also prevents lenders from using your age against you when you apply for a personal loan — unless you’re a minor.

Personal loans can be useful financing in some cases, but they aren’t great for every scenario or borrower.

✅ Benefits

  • Lower APRs than a credit card

  • Doesn’t require collateral

  • Funding in as little as 24 hours

  • Online and in-person applications

  • No limits on how you use the funds, unlike a car or home loan

❌ Drawbacks

  • Fixed monthly payments can be inflexible

  • Difficult to qualify while rates are high

  • Prepayment penalties may prevent refinancing

  • More expensive than secured financing like a home equity loan or HELOC

Consider these factors when comparing personal loan providers:

  • APR. The APR is the quickest way to compare the total cost of a loan, especially when some lenders charge origination fees.

  • Origination fee. Consider the fee amount and whether it’s added to your balance or deducted from the funds you receive. If it’s deducted from your funds, you may need to apply for a larger loan.

  • Loan amounts. Don’t waste your time with lenders that don’t offer the amount you need.

  • Monthly cost. Many lenders have calculators on their websites that allow you to tally the monthly cost of a loan. If the cost is out of your budget, consider another provider.

  • Requirements. Make sure you meet the lender’s basic eligibility requirements before you apply to avoid wasting your time.

  • Type of lender. If you prefer to meet with your lender in person, consider a bank or credit union. Need money as soon as possible? Look for lenders that fund loans online.

  • Reputation. Read reviews and news articles about the lender. If you find that a financial institution, say, has a history of opening fraudulent accounts in customer names, consider another option.

  • Prepayment penalties. Some lenders charge a fee if you pay off a loan early to make up for the interest you would’ve paid had you stuck to the term. Avoid these lenders if you plan on refinancing your loan when rates come back down.

Consider these financing options before you apply for a personal loan.

  • Credit cards may be easier to manage with smaller expenses, especially if you can pay down your balance before the end of the month.

  • Home equity loans and HELOCs typically have lower rates and can take on heftier home improvement projects.

  • Personal lines of credit give you access to a credit limit that you can withdraw from as needed and receive cash. These can be helpful for large ongoing projects, where it’s difficult to predict the exact cost and you need to pay in cash.

Anna Serio-Ali is a trusted lending expert who specializes in consumer and business financing. A former certified commercial loan officer, Anna's written and edited more than a thousand articles to help Americans strengthen their financial literacy. Her expertise and analysis on personal, student, business and car loans has been featured in Business Insider, CNBC, Nasdaq and ValueWalk, among other publications, and she earned an Expert Contributor in Finance badge from review site Best Company in 2020 for her work at Finder.