How Do Personal Loans Work + How Should You Use Them?

Personal loans are probably more common than you realize. Consumers use them to cover unexpected expenses, consolidate debt, finance home renovations, and more. Someone in your life has probably taken one out at one time or another, even if we don’t talk about it every day.

These loans can be appealing when you’re short on cash. They offer fast funding and relatively low fixed rates, and you can use them for almost anything you can think of. But they’re not the right solution for every person or circumstance, and there are more than a few risks to consider before deciding whether a loan might be right for you. Here’s how personal loans work and when they make sense (and when they don’t).

What is a personal loan?

A personal loan is an installment loan with a fixed repayment term that you repay in equal monthly repayments, also called installments. Personal loan terms are typically between two and seven years, but you can find some as short as one year or as long as 10 years (sometimes more).

You receive a personal loan as a lump sum of cash shortly after being approved. Loan amounts often fall between $1,000 and $50,000, but some lenders offer even smaller or larger loans (and the maximum you’re approved for typically depends on your creditworthiness).

Types: Secured vs. unsecured

There are two main types of personal loans: secured and unsecured.

Secured personal loans require you to put down collateral when applying — valuable assets like savings accounts, cars, or even expensive jewelry can be used as collateral. Collateral is used to secure your loan and serves as a sort of buffer between you and your lender. If you can’t pay back your loan, your lender keeps the asset you pledged to try to recover its losses. This makes lenders more comfortable lending to riskier borrowers. Secured loans may also have lower rates than unsecured loans.

Unsecured loans, on the other hand, don’t require collateral. Instead, your credit profile will speak for you. This means these are harder to qualify for than secured loans as a rule, but you also don’t risk losing anything.

This is similar to the differences between unsecured and secured credit cards.

Use cases

You can use the funds from a personal loan to pay for a wide range of personal expenses, from bills to large purchases you’re planning to emergencies. For example, you could take out a personal loan to pay a massive veterinary bill or consolidate high-interest credit card debt to make it easier to repay.

Lenders can decide what loan purposes to allow and restrict, but debt consolidation, large purchases, and emergencies are generally fair game.

Other approved uses usually include:

Home remodeling or renovation

Moving costs

Weddings and honeymoons

Vehicle purchases

Vacations

Medical expenses

Restricted uses for personal loans usually include:

Paying for higher education

Purchasing investments

Buying real estate

Making a down payment on a home

Starting or funding a business

Gambling

What’s the application process like?

You can apply for personal loans at banks, credit unions, and online lenders. The amount of money you can borrow varies from lender to lender, and it also depends on your credit profile, debt, and income. Most lenders will check to see if you prequalify for a loan with no impact on your credit, which I definitely recommend doing before you formally apply.

After applying and getting approved for a personal loan, you’ll typically only have to wait a few days or up to a week to get the funds. Many lenders, like SoFi and Avant, even offer same- or next-day funding, provided your application is complete and you’re a really strong candidate.

Interest and fees to be aware of

Personal loans typically have fixed interest rates that will never change, which sets them apart from credit cards. Variable-rate personal loans aren’t nearly as common as fixed-rate loans.

When you shop around for personal loans, you’ll see rates expressed as APRs. This term stands for “annual percentage rate,” and it combines your simple interest rate and any fees charged on the loan to represent your annual borrowing costs. APRs give you a more accurate picture of how much a loan will cost you than just the interest rate would (and fortunately, the federal Truth in Lending Act requires lenders to give you an APR).

For personal loans, origination fees are one of the main fees you have to worry about. This is a one-time fee charged upfront and usually deducted from your loan balance, and it can range from around 1% to 12%. Many lenders also charge late fees if you miss payments.

Repayment

Because personal loans have fixed repayment terms and fixed rates, your monthly payments will be broken into equal amounts. You’ll make payments until the full amount is repaid and start repaying the principal — the amount you borrowed — with interest right away.

When a personal loan might make sense

You can technically use a personal loan for many things. But like any financial product, some reasons to get a personal loan are much better than others.

Here are a few of the most common uses. For any of these, make sure you can afford the monthly loan payments before doing anything else.

Debt consolidation

If you have high-interest debt from other loans and credit cards, you can take out a new personal loan to repay that debt and effectively combine your balances. This is called debt consolidation, and it can make your debt easier to pay off and save you a ton on interest, plus give you just one monthly payment and rate to worry about instead of several.

Personal loans are just one way to consolidate debt, but they’re a good choice because they often have better rates than credit cards. The average rate on a two-year personal loan is currently 12.33%, according to Federal Reserve data, while the average credit card rate is 21.76%.

Debt consolidation is especially great if you have good-to-excellent credit (a FICO score of 670 to 739 or 800 and above, respectively) because you’re likely to qualify for the best rates.

Large purchases

A personal loan might be the right choice if you’re planning for a big expense and want to spread the cost over one or several years. That way, you don’t have to wait to buy the thing or do the project you need.

This can be a smarter route than Buy Now, Pay Later (BNPL) financing because a personal loan typically gives you longer to pay off a purchase and tends to have a more straightforward repayment structure.

Emergency expenses

Sometimes, the unexpected happens. An appliance stops working, or you find yourself in the hospital with expenses insurance doesn’t cover. A personal loan could provide welcome relief when life throws you a financial curveball and you don’t have enough in your emergency fund. Just be careful to consider the long-term repercussions of taking on debt to get out of a bind and only borrow as much as you need (and not a penny more).

When a personal loan might not make sense

If you fit any of the following descriptions, you probably shouldn’t get a personal loan right now.

You struggle with overspending

Getting a personal loan to cover a big purchase or consolidate debt isn’t a solution to overspending. If you know you have trouble sticking to a budget, try tackling that before you commit to a monthly payment that will only spread you thinner. A personal loan is a lump sum, and that can be dangerous when you lack discipline.

You have very poor credit

While you may be able to qualify for a personal loan with damaged or even limited credit, and some lenders “specialize” in loans for these situations, it’s not always in your best interest to go through with a loan. This is because your credit is typically used to determine your interest rate, and you’re likely to get stuck with the highest APRs if you’re seen as less creditworthy.

If you’re on the fence about getting a personal loan and can afford to wait a little while to improve your credit, I definitely recommend it. If you can’t, check out the best bad-credit loans.

You don’t really need a loan right now

This one goes without saying, but don’t get a loan if you don’t absolutely need it. You’re going to be locked into a repayment schedule for a year or more and won’t have any flexibility over those monthly payments. A personal loan doesn’t necessarily need to be a last resort, but it probably shouldn’t be your first option every time money is tight, either.

How to choose a personal loan

To get a loan that’s right for you, follow these steps.

Know your credit: Generally, the higher your credit score, the more likely you are to see a better interest rate on a personal loan. If you have at least a good FICO credit score (670-739), you'll often have more options and lower rates, but there are options for bad- and fair-credit borrowers, too.

Compare loan terms: Pay close attention to not just the APRs you might qualify for but also the repayment terms and loan amounts available. Look for lenders that have the loans you need available, but know that your loan offer may not be at the lender’s highest borrowing range.

Check out lender reputations: Even if a lender is legitimate, that doesn’t mean it’s nice to work with. Do a little digging into what people have to say about a lender you’re considering by reading Better Business Bureau (BBB) and Trustpilot reviews. If you’ve got a few minutes, look up the lender in the Consumer Financial Protection Bureau’s (CFPB’s) Consumer Complaint Database to see how many complaints have been filed.

Alternatives to personal loans

Balance transfer credit cards

With strong credit, you may be able to qualify for a credit card with a 0% APR intro offer on balance transfers. 0% intro APR credit cards offer an introductory period with no interest, so you can transfer balances from other credit cards and work to pay them off without them growing. These intro periods can range from 12 to 21 months.

For example, the Citi Double Cash^® Card offers a 0% introductory APR on balance transfers for 18 months (then 18.74% - 28.74% (Variable)). It can give you a grace period to pay off your debt without incurring interest charges, though you’ll want to be sure to pay off the balance before that grace period ends.

For more details, check out our full Citi Double Cash Card review.

Credit-builder loans

Credit-builder loans, a type of secured personal loan, might be a good option if you like the idea of an unsecured personal loan but have a limited credit history. Making regular timely payments can be an excellent way to build or rebuild credit. And, if you already have other types of credit, adding a secured loan can diversify your credit mix, which accounts for up 10% of your credit score.

Home equity loans

A home equity loan lets you borrow against the equity you’ve built in your home. In other words, you use the value you own in your home as collateral. Some consumers prefer home equity loans to personal loans because they might have a lower interest rate. A home equity loan can be a good idea for homeowners who plan to use the funds to renovate their homes and increase the property’s value.

The main drawback to home equity loans is that your home serves as collateral, which means you could lose your house if you default on the loan.

Home equity lines of credit (HELOCs)

As with home equity loans, HELOCs allow you to leverage the equity in your home to borrow. You can use the funds for any purpose, but they are commonly used for home improvement projects. However, unlike home equity loans are generally lump-sum payments, while HELOCs provide a revolving line of credit you can draw from (like a credit card).

Similar to a home equity loan, your home serves as collateral with a HELOC. Because of this, these loans might have lower interest rates, which makes them an attractive alternative to personal loans. Just remember to account for the upfront fees and costs.

A HELOC could be a good option if you have considerable equity in your home and want a potentially inexpensive way to borrow money. But any loan that uses your house as collateral is inherently risky because you’re dealing with the possibility of foreclosure. If you have any reservations about your ability to repay a HELOC or home equity loan, stop and consider other options.

FAQs

Bottom line

Personal loans are installment loans you can use in numerous ways, such as consolidating high-interest loans, funding a home renovation project, or paying for an unexpected expense. But do your due diligence and run the numbers to make sure it makes sense.

The best personal loan for one person might not be the best personal loan for you. Compare a few lenders, and don’t rush into any decisions. Have a clear understanding of how the payments will impact your budget and follow a plan to pay off the loan.