How do personal loans work?

Got a big expense coming up? Or maybe you've experienced a financial emergency and face a big bill. Either way, you need cash, and a personal loan could be the solution you're looking for. 

These loans could help you reach just about any financial goal. They can be especially useful for larger purchases since you repay in installments over time. But that's only the basics of how personal loans work. 

If you want a look at the finer points of loan terms and repayment, we’ve got you covered. We'll break down key terms and steps in the process, from applying all the way through repayment.

How does a personal loan work?

A personal loan involves borrowing money from a bank, credit union, or other lender. You can generally use it for any legal purpose, and you pay it back in installments over a fixed repayment period, usually two to seven years. These loans typically have the same payment amount for the lifetime of the loan that includes both the interest and the principal. 

Personal loans are typically unsecured, which means they're not backed by collateral or something of value you own that the lender can seize and sell if you don't make payments. This means you don’t risk losing any property, but you'll likely pay higher interest rates than you would with a secured loan.

Personal loan terms

Each loan will have a set of terms that dictate how it will work. This includes the rates and fees, plus details of when and how much your payment will be.

Here are the key elements of a personal loan.

Interest rate

Interest rates are basically the cost of borrowing money. You pay back the principal—the money you borrowed—plus the interest fees. Lenders make a profit off personal loans by pocketing the interest you pay (and any loan fees).

The interest rate is what determines the interest fees you pay. Most lenders calculate interest monthly.

Do personal loans have fixed or variable rates?

Personal loan interest rates can be fixed or variable. Fixed interest rates stay the same over the lifetime of the loan. This is how most personal loans work. 

Variable interest rates can change throughout the loan term. This could make it more challenging to estimate the overall cost. It's worth weighing the pros and cons of fixed vs. variable personal loans before deciding which is right for you.

Fees

Personal loans usually come with an origination fee. This covers the cost of processing the new loan. It's often a percentage of your loan amount, and it typically gets added to your loan balance.

Lenders may also charge late fees if you don’t make payments on time. Some charge prepayment fees if you pay off your loan ahead of schedule. If you plan on making extra payments, look for a loan without prepayment fees.

All of the loan fees should be listed in the terms. Make sure you understand all the potential costs before signing the loan agreement.

Annual percentage rate (APR)

Your loan's annual percentage rate (APR) is the yearly cost of borrowing the money. This includes the interest rate plus the lender fees. 

The higher the APR, the more expensive the loan will be. 

Since APR includes both interest and lender fees, it's often the best way to compare the overall cost of borrowing across lenders or even different credit products.

Discounts

Some lenders offer personal loan borrowers a discount if they enroll in autopay (automatic transfers from your bank account toward your loan balance). You don't have to do this, but even a small rate decrease could save you some decent money over the life of the loan. Plus, automatic payments could help you avoid paying late.

Term length

Your personal loan term length is the amount of time you have to pay back what you owe. Most personal loans range from two to seven years. Longer loans tend to have smaller monthly payments but cost more in total interest fees.

The term length will often be listed in months since you typically make monthly payments. This tells you how many payments you'll need to make in total to pay off the loan.

Monthly payments

Your monthly payments are the amount you must pay per month to avoid late payment penalties. These are usually fixed with personal loans, meaning you pay the same amount each month. Payment size depends on the amount you borrow, your APR, and the length of your loan term.

The process to get a personal loan

Here's a closer look at the steps to take to get a personal loan.

1. Compare personal loan lenders and prequalify

Many personal loan lenders have online prequalification tools to check whether you might qualify and see approximately how much you could borrow. These tools do what's known as a soft credit check, which doesn't impact your credit score.

It's best to compare rates from three to five companies before you make your choice. Look at the monthly payment, the APR, the fees, and the loan terms to make sure you're comfortable with them. Don't just focus on the monthly payment—consider the total cost of the loan, too.

2. Apply for a personal loan

Once you've chosen a lender, it’s time for a more in-depth application. You may be able to do this online. You'll generally need to provide:

• Your income

• Your Social Security number

• How much you want to borrow

• Your reason for borrowing

• Information about your employer

• A bank account number (to receive funds if approved)

If you're working with an online lender, you might find out whether your application has been approved on the same day. However, it could take a few days, or potentially longer, to get a decision in some cases.

3. Review and accept personal loan terms

If the lender approves your application, it provides you with the loan terms. This should include how much you can borrow, how long you'll have to repay, what fees you'll owe, and what your monthly payments will be. 

This should be pretty similar to the prequalification you got in the first step, but this isn't guaranteed. An actual credit application involves a more in-depth hard credit inquiry and dive into your finances. This could impact the interest rate, fees, or amount you can borrow.

4. Receive your personal loan funds

After you accept the loan terms, the lender deposits the funds in an account you specify. How long this takes depends on which lender you work with, but you usually receive your money within a few days or so.

How does repayment on a personal loan work?

You make monthly payments on your personal loan, usually for a fixed amount. Your monthly payment varies depending on:

• How much you borrow

• Your loan term

• Your interest rate

• Whether you receive an autopay discount

• The lender's fees

Say you took out $10,000 with an 18% APR and a 36-month loan term. Your monthly payments would come out to about $362 per month. 

A portion of this payment would be principal—repayment of the $10,000 you received. The rest would be interest and fees—the money you pay the lender for loaning you the cash.

The $362 in our example is the minimum you must pay to keep your loan in good standing, but you're free to pay more if you want. This could help you pay your loan off faster, and pay less in total interest. Check to see whether your lender has a prepayment penalty first. If it does, you must weigh the potential costs when deciding whether it's worth it to you.

How personal loans differ from credit cards and other loans

Personal loans are installment loans. They are repaid in installments, meaning you make fixed monthly payments over a certain period of time. 

Most personal loans are unsecured loans, meaning they're not backed by any collateral or something of value you own. Mortgage and auto loans are secured loans because they're backed by collateral, like your home or car. 

Credit cards are another type of unsecured debt, known as revolving debt. They represent a reusable line of credit. This means you can borrow, repay, then borrow again, up to your credit limit. 

Revolving credit lines typically don't have fixed payments or interest rates. Your balance—and how quickly it grows—can fluctuate over time, leading to less-predictable monthly payments.

What's next

Now that you understand more about how personal loans work, you can compare your options with confidence. Learn more about how to maximize your approval odds if you're worried about the application process. Or take the next step and check your rates through Achieve Personal Loans with no impact to your credit.