How Do Personal Loans Work?

There are all kinds of “debt instruments” consumers can use in a budgetary crisis, including credit cards, mortgage loans, and more. But personal loans are among the most versatile and flexible loans you can take out. Because they can be used for all kinds of things, ranging from medical expenses to higher education to buying a new flatscreen TV, they’re very popular options for borrowers of all credit score ranges. However, some people are surprised by how personal loans work, particularly by how they must repay the loan by the end of their term limit. This guide will break down how personal loans work and how you can ensure that you take out a smart personal loan if you ever need to apply for one . Let’s get started.

What is a Personal Loan?

A personal loan is typically a fixed-rate loan that borrowers can take out for various purposes, such as home improvements, car purchases, medical bills, debt consolidation, and much more. Personal loans can often be used at the discretion of their borrowers, although they are usually taken out with a specific or defined reason at first. Because they can be taken out and used for so many things, personal loans vary widely in their annual percentage rates or APRs, fees, and term limits.

Types of Personal Loans

There are all kinds of personal loans offered by a variety of lenders and financial institutions. Lenders sometimes advertise the same kinds of personal loans under different names to distinguish themselves from their competitors. Here are just a few common personal loan types:

• Boat loans
• Car loans
• Debt consolidation loans
• Medica loans
• School loans
• Moving loans
• Furniture loans
• Wedding loans
• Vacation loans
• Emergency loans
• And more

In short, there’s a personal loan for almost any need or occasion. Thus, many people use personal loans as versatile financial tools to help them get out of a tight spot or purchase expensive items faster than they would be able to through traditional saving strategies.

How Personal Loans Work

Personal loans are so-called “installment loans.” This means that when you are approved for the loan, and you accept the terms of the contract, you get a one-time payment for the total loan amount between one or two business days after acceptance. You can then use the money in a hurry if you need the lump sum for an emergency, like a big medical bill or paying for a new semester of college. You’ll then be required to make flat payments over a set timeframe called the loan term. These payments are usually structured to pay the same amount with each billing cycle for the loan’s entire duration. By the loan’s end, you’ll have paid back the full amount with interest. Interest is usually calculated in the flat payment amounts. This can be positive or negative, depending on your financial situation and discipline. With personal loans, you have to pay the same amount every month regardless of how much of the loan remains. For example, if your flat loan payment is $100 for the duration of the loan, you have to pay $100 every month. You can’t pay $50 one month and $150 next month. If you fail even one monthly payment, you could default on the loan, leading to several negative side effects like a hit to your credit score, late fees, and more.

Interest on Personal Loans

Personal loans are usually packaged with fixed interest rates. Thus, the interest you pay for each billing cycle doesn’t change as you get closer to paying off the loan in full. However, some personal loans do have variable interest rates, which means that the interest rate could change based on market factors or other things like your credit score, late payments, etc. Individuals can compare the interest rates on personal loans to determine whether a given loan contract will be a good fit for their budget and needs. It’s also helpful to compare APRs on loans rather than interest rates alone because APRs include the total cost of the loan you’ll pay every month, including any extra fees or charges the borrower may add.

Are Personal Loans Good Tools?

They can be. Like other debt instruments, personal loans can help individuals pay for things quickly when they don’t have the cash in their bank account. For example, a personal loan can help you repair your car likely so you can get back to work if you don’t have enough money to cover emergency repairs yourself. Then you can pay off the personal loan over time. Some people also use personal loans as debt consolidation tools. With debt consolidation loans , you take out a personal loan for the entire amount of your collected debts, such as credit card debt, debt from another personal loan, and so on. You then use the personal loan lump sum to pay off those debts. In exchange, you pay back the debt’s total amount to a single lender (the lender of the debt consolidation loan). Many people find this debt repayment strategy to be more manageable as they only have to pay a single bill with one interest rate. Ultimately, whether or not a personal loan is a good idea depends on your financial strategies and self-discipline. Like other debt instruments, personal loans can be risky or cause your credit score to drop if you fail to pay them back on time or at all. Personal loans can also be tricky to handle compared to other debt instruments like credit cards . Credit cards often allow you to pay back a minimum amount or more each month rather than a flat amount as you gradually work down any credit you take out on the card.

Who Qualifies for Personal Loans?

Anyone can qualify for a personal loan. But as with other types of debt instruments, most high-quality personal loans are only available to people with good credit , excellent financial histories, and so. The best personal loans, with high lump sum amounts and low-interest rates, will require:

• A credit score of 700 or above
• Good financial history, especially with the lender of the personal loan in question

Other loans with higher interest rates and less favorable terms can be acquired if you have less than stellar credit history. But keep in mind that many subpar personal loans come with strings attached or potential traps. For instance, so-called “payday loans” have extremely high interest rates and can sometimes trap people without a lot of money in endless cycles of debt. They fail to repay the payday loan, which has a high interest rate and several late fees, which they then default on, making their credit score drop and forcing them to take out another low credit score payday loan from another lender. Some personal loans, called secured personal loans , require that you provide collateral as insurance against defaulting on the loan. This can be something like your car, another valuable piece of property, or even payment in cash for less than the loan amount.

How to Ensure You Take Out Personal Loans

When comparing personal loans, try to look for loans that:

• Have low interest rates or low APRs. You’ll pay less for a personal loan with a low interest rate over its lifespan than a personal loan with a high interest rate
• Few or no extra fees. Extra fees can add to the loan’s total or make it difficult to pay for your other bills
• No late fees
• Good term lengths. Some high-value personal loans have very short terms, meaning you’ll need to pay huge sums of cash with each billing cycle. Longer term lengths are usually easier to manage for most borrowers

Summary

In the end, personal loans are only as effective as the people who take them out and use them responsibly. For example, personal loans can help you pay for emergency costs without emptying your bank account when used correctly. Or they can help you pay for expensive items or services you wouldn’t be able to afford for several years if you saved usually. But it’s important to use personal loans responsibly and to pay back their total amounts on time, both to protect your credit score and to ensure that you don’t pay extra late fees. Want to learn more about personal borrowing or need resources for personal loans and credit cards? In either case, Seek Capital has the resources to help. Check out our site today. Sources: Previous Article Personal Loans: What to Know Before You Apply | Experian Debt Consolidation Definition | Investopedia What is a Credit Score – Credit Score Range | Equifax What Is a Secured Loan? | Experian