A personal loan is a type of installment loan, which allows you to borrow a set amount of money and pay it back in monthly payments with interest over the course of the loan. When you pay back the loan in its entirety, the account is then closed.
There are two types of personal loans: secured and unsecured. A secured personal loan is guaranteed by collateral that can be claimed by the lender if you are unable to repay the borrowed money. Most personal loans are unsecured and not backed by collateral, which causes them to charge higher interest rates than some other types of loans. Your interest rate will also depend on your credit history and score.
Why are personal loans commonly used?
Personal loans can be helpful in a variety of situations, including debt consolidation, making expensive purchases, emergency expenses, and much more.
- Debt consolidation: If you have high-interest debts from other loans or credit cards, you can consolidate them into a single loan with a lower interest rate to make your payments more manageable. Balance transfer credit cards accomplish the same thing—sometimes with introductory offers of low or no interest—so, it’s important to weigh both options. Using a personal loan for debt consolidation may be best if you are not approved for a balance transfer credit card.
- Large purchases: Home updates, such as installing a new roof or swimming pool, are an example of expensive projects that could be funded with a personal loan. Other large items, like a Peloton bike or a new bed, are often purchased using buy now, pay later (BNPL) financing, which is another type of personal loan.
- Emergencies: A personal loan can be used to cover emergency medical expenses, which unexpectedly appear in the form of surgeries, dental procedures, ambulance rides, fertility treatments, and even veterinary bills for pets.
- Life events: Important life events are often accompanied by a costly celebration, like a wedding, milestone anniversary or birthday, and bar or bat mitzvah. While it’s important not to let a social event drive you into debt, a personal loan is commonly used to help alleviate the initial financial burden.
- Credit score improvement: Taking out a personal loan could positively impact your credit score if you make the payments on time. If you struggle with budgeting or timely payments, however, then borrowing more money may not be the right solution.
11 definitions to help you choose a personal loan
Finding a personal loan—for any reason—can be tough when the terms are filled with unfamiliar vocabulary words. It’s important to learn some of the definitions associated with personal loans to feel self-assured about choosing one that’s beneficial.
- Lender - Also referred to as a creditor, your lender is the financial institution from whom you are borrowing money.
- Term - The term is the length of time you have to repay your personal loan, usually between one and five years. A longer term typically has a higher interest rate and lower monthly payments, while a shorter term means less interest and higher monthly payments.
- Principal balance - The amount of money you borrow (without any interest or fees) is the principal balance. As you make your monthly payments, the principal is reduced—though not by the exact amount of your payment, since it is also applied towards interest and fees first.
- Annual Percentage Rate (APR) - All personal loans have an APR, which is the yearly cost of borrowing money displayed as a percentage. A lower APR is preferable because it means you’ll pay less in interest for your personal loan.
- Fixed monthly payment - This is the set amount you’ll pay each month, which is applied towards both the principal balance and interest of your personal loan.
- Fixed interest rate - This is a fixed percentage that can be used to calculate the interest you’ll pay for your personal loan. It will not change during the term of your loan, making it simple to plan and budget accordingly.
- Variable interest rate - Also known as a floating or adjustable rate, this is an interest rate that can change over the lifetime of a loan—usually because it is based on a reference rate.
- Origination fee - This fee can be charged by a lender for processing your application and allowing you to borrow money. If an origination fee is charged, it is usually due when you receive the loan money or deducted from the principal amount, so know what to expect before applying.
- Late fee - Common for any type of loan, this is charged if you fail to make your personal loan payment on time. It can appear in the form of a predetermined fee or a percentage of your balance.
- Exit fee - Sometimes called a prepayment fee, this can be charged by a lender if you pay off your loan early. While it may seem positive to repay your loan faster than anticipated, remember that the lender expects to collect interest over the full term. For this reason, a penalty may be charged.
- Pre-approval - Also called pre-screening or pre-qualification, this occurs when a lender offers you an opportunity to apply for a loan based on the belief that you’ll qualify. Being pre-screened doesn’t guarantee approval, but it’s usually a good indication.
Read the fine print
With proper research and a budget prepared to support repayment, a personal loan can be a great option for funding high-priority purchases and boosting your credit score. Just make sure that you fully understand the terms and conditions of a loan before applying—this will help you find competitive rates and avoid hidden fees in the future.