How do personal loans work?
Personal loans are a type of installment loan. That means you borrow a fixed amount of money and pay it back with interest in monthly payments over the life of the loan — which typically ranges from 12 to 84 months. Once you’ve paid your loan in full, your account is closed. If you need more money, you have to apply for a new loan.
Loan amounts vary from lender to lender, but typically range from $1,500 to as much as $100,000. The amount you qualify for is based on your credit health (i.e. how confident creditors are that you’ll pay them back if they lend you money).
It’s important to think about why you need the money and then choose the type of loan that’s most appropriate based on your current financial situation.
Personal loans come in many flavors and can be secured or unsecured. With a secured personal loan, you have to offer up collateral or an asset that’s worth something in case you can’t pay the money you owe back. If you default, the lender gets that asset. Mortgages and auto loans are examples of secured debt.
With an unsecured loan, the most common type of personal loan, you aren’t required to put up collateral. If you don’t pay back the money the lender can’t garnish any of your assets. That’s not to say there aren’t repercussions. If you default on an unsecured personal loan it will hurt your credit score, which raises the cost of borrowing, in some cases dramatically. And the lender can file a lawsuit against you to collect the outstanding debt, interest and fees.
Unsecured personal loans are typically used to finance a big purchase (such as a wedding or vacation), to pay down high-interest credit card debt or to consolidate student loans.
Personal loans are issued as a lump sum which is deposited into your bank account. In most cases, you’re required to pay back the loan over a fixed period of time at a fixed interest rate. The payback period can be as short as a year to as long as ten years and will vary from one lender to the next. For example, SoFi, an online lender, offers personal loans with terms between three and seven years. Rival Marcus by Goldman Sachs offers loans with terms from three to six years.
Borrowers who aren’t sure how much money they need can also take out a personal line of credit. This is an unsecured revolving line of credit with a predetermined credit limit. (In that respect, it’s a lot like a credit card.) The interest rate on a revolving line of credit is typically variable, meaning it changes with the prevailing interest rate in the market. You only pay back what you draw down from the loan plus interest. Lines are commonly used for home improvements, overdraft protection or for emergency situations.